Example of How Amortization Affects Financial Statements
The primary goal of a business, large or small, is to make a profit. The income statement -- also known as the profit and loss statement -- helps finance and operational managers track profitability. Due to generally accepted accounting principles, amortization is one of the few non-cash line items on the income statement. As a result, amortization affects each financial statement in a different way.
An asset is anything used to create value for the company. Common assets are inventory, equipment and real estate. These are referred to as tangible assets because they are physical objects with a physical location. Intangible assets have no physical location; however, they create value for the company. Common intangible assets are copyrights, trademarks and patents. Like tangible assets, intangible assets have a defined useful life.
For example, a patent has a useful life -- legally -- of 20 years, providing it isn't rendered obsolete first. In order to accurately portray the value of a company, accountants write off assets according to an established useful life. The process of writing off a tangible asset is depreciation; the process of writing off an intangible asset is amortization.
Assets, liabilities, and stockholders' equity are the three main sections of the balance sheet. The balance sheet equation is: assets = liabilities + stockholders' equity. Analysts look at the balance sheet to gauge the net worth of a business. The balance sheet also provides a list of assets in order of liquidity. Amortization is used to write off the value of an intangible asset over its useful life. Intangible assets are also listed on the balance sheet, so as the intangible asset is used, you will notice a decrease in the asset value of the company on the balance sheet, which also reduces stockholders' equity to "balance out" the equation.
Unlike the balance sheet, which is a snapshot in time, the income statement provides an overview of all sales and expense activity over a given time period. Amortization, like depreciation, is expensed on the income statement, which artificially lowers net income, since it is a non-cash expense. In order to get a true cash position of a company, you must look at the cash flow statement.
The cash flow statement is the bridge between the balance sheet and the income statement. The three sections of the cash flow statement are cash flow from operations, cash flow from investing and cash flow from financing. Amortization falls in the operations section. Because amortization is a non-cash expense, it is added back to net income for a true cash position.