Definition
Amortization is an accounting concept that is used by companies to reduce the book value of a borrowing over a set period. Amortization focuses on distributing or spreading out loan repayments over a period. Amortization helps in reducing a company's taxable income during the entire lifespan of an asset.
Example
Amortization Expense = (Initial Value – Residual Value) / LifespanSuppose a company owns a patent right for 20 years. The company has spent $20,000 for creating the patented product. Thus, it can record $1,000 per year as amortization expense towards the patent ($20,000 / 20 years).
Why it matters
By using the concept of amortization in accounting, businesses can easily know their costs over time. If it's for loan repayment, amortization schedules tell the exact portion of a loan payment classified as interest vs. principal.It is mainly used for tax saving purposes as it allows the deduction of interest payments during the loan tenure.By amortizing intangible assets, a business can reduce its taxable income and overall tax liability. This allows investors to get a better insight into the company's true earnings.