Amortization expense is the periodic cost allocated for an intangible asset over its estimated useful life. Intangible assets, such as patents, copyrights, trademarks, and goodwill, have a specific useful life, and their costs are spread out over that time period.
Amortization expense is recorded in the income statement as a non-cash expense, which means it reduces a company’s net income without affecting its cash flow. On the balance sheet, the amortization expense reduces the carrying value of the intangible asset.
Example of an Amortization Expense
Here’s an example to illustrate the concept of amortization expense:
XYZ Company acquires a software license for $120,000, which allows them to use a specific software for the next 4 years. The company decides to amortize the cost of the software license over its 4-year useful life.
To calculate the annual amortization expense, the company divides the total cost of the software license by its useful life:
Annual Amortization Expense = $120,000 / 4 years = $30,000 per year
XYZ Company would record the following journal entries each year for 4 years:
- Debit “Amortization Expense” for $30,000 (Income Statement)
- Credit “Software License” (Intangible Asset) for $30,000 (Balance Sheet)
At the end of each year, the carrying value of the software license on the balance sheet would be reduced by $30,000. After 4 years, the carrying value of the software license would be zero, indicating that the cost of the license has been fully amortized.
In this example, the annual amortization expense of $30,000 reduces the company’s net income, but it does not affect the company’s cash flow, as it is a non-cash expense.