Definition:

Amortization typically implies reducing the cost of an intangible asset over time. It is closely related to Depreciation which is a similar concept applied to tangible assets like vehicles or machinery. These costs are recognized in the “Depreciation & Amortization” (D&A) section of the income statement. D&A also reduces the value of assets on the Balance Sheet.

Example:

A company owns a patent for a machine that expires in 10 years. This patent is an asset that could be sold and has a monetary value, but we know that value becomes zero in 10 years. To reflect this the company amortizes its value over time by charging 10% of its value to expenses (D&A) each year (i.e. 1/10 years).

Why it matters:

Any asset with a long life provides value over that life, not only in the year it is bought or created. D&A charges the fair share of the cost of the asset to the income statement (P&L) each year. It is also important to recognize that the asset will need replacing at the end of its life, so even though cash is not being spent each year, omitting D&A would overstate the long term profitability of the business.