Definition:
Amortization is the same basic idea as depreciation, but it applies to intangible assets. These days, intangible assets are often a big part of companies’ balance sheets. Items such as patents, copyrights, and software are all assets – they cost money to acquire, and they have value – but they aren’t physical assets like real estate and equipment.
With amortization you spread the cost of the software, copyright, patent, etc. over the useful life in which it will be used, in the same way you depreciate a physical asset.
Example:
Take a new piece of software, your company had to buy it, or maybe you had to develop the software. The company then must amortize the software over its useful life.
Book Excerpt:
(Excerpts from Financial Intelligence, Chapter 11 – Assets)
Some software companies, for example, are famous for spending considerable sums on R&D, then amortizing those sums over time, thus making their profits look higher. Others choose to expense R&D as it is incurred – a more conservative approach. Amortization is fine if the R&D actually expected to generate revenue, but not if it isn’t. You need to know how aggressive or conservative your company’s policies and practices on amortization are. Like depreciation, amortization decisions can often have a sizeable effect on profitability and owners’ equity.
