Amortization is an accounting term for spreading the cost or value of certain things — like loans or property — over time.
The word "amortize" has its roots in the Latin for "to kill off," and the process involves a gradual diminishment of value, effectively killing it off over time.
A loan is slowly disposed of through regularly scheduled payments. Similarly, the value of acquired property must be spread out to keep the asset from staying on a company's ledger indefinitely. It's how assets are valued for tax purposes.
Amortization involves intangible assets, such as patents, trademarks, licenses and copyrights. We'll get to tangible assets, like equipment, machinery and cars, shortly.
If a company acquired a license valued at $10,000, and the license expired in 10 years, the value would have to be amortized, or spread out. So, each year for 10 years, a $1,000 ledger entry would be entered.
Does that sound like depreciation? Here's the difference: Depreciation applies to tangible assets.
A contractor's truck is a tangible business asset that enables the contractor to earn income. The contractor's accountant would determine the useful life of the truck, and depreciate its value over that time period.
Depreciation is tax-deductible, which allows businesses to recover the costs of things they buy and use. For tax-based depreciation, a business must follows strict IRS rules about how certain assets are to be devalued over time.
You're probably familiar with depreciation in another sense: for the personal property you own. A new car, for example, notoriously depreciates quite a bit right when you drive it off the sales lot.
Yet another big word to watch for...
A third related concept is depletion. It's an accounting method for recognizing reductions in assets that are natural resources, such as oil reserves, timber and more.
Do you feel smarter now? Good! Understanding concepts like these is important for financial literacy.