What Constitutes Amortization in EBITDA?

Earnings before interest, taxes, depreciation and amortization -- commonly referred to by the acronym EBITDA -- takes net income and adds back interest, tax, depreciation and amortization expenses. It is an often-used profitability measure for companies with high debt levels. Many investors use it to measure an entity’s true operating performance. The amortization expense that is added back to the earnings amount represents the periodic consumption of intangible assets reported on the income statement.

Intangible assets are long-term legal rights and competitive advantages developed and acquired by a business entity. They are used in operations and provide benefits over several accounting periods. Examples of intangible assets include patents, copyrights, franchises and trademarks. An intangible asset is amortized because its value diminishes over time.

Amortization is affected by the cost of the intangible asset, which consists of the amounts paid to acquire the asset in a transaction with external third parties. This cost is the amount recorded as an asset. If a company internally develops an intangible asset, its costs are expensed immediately and it is not subject to amortization. Only direct costs spent to secure the internally developed intangible asset are recorded as the asset’s value. Examples of direct costs are legal fees, registration or consulting fees and design costs, all of which are subject to amortization.

The straight-line method is usually used to amortize intangible assets. Calculate the periodic amortization amount by dividing the cost of the intangible asset by the asset’s estimated life in years. Some intangible assets can have different amortization periods. For example, a patent is amortized over its estimated life or its remaining legal life, whichever is shorter.

Amortization expense is reported on the income statement in every accounting period over the intangible asset’s life or the amortization period. The expense reported does not vary from period to period; a recalculation of the expense occurs only if the number of years of the asset’s amortization period changed. The expense reported is one of the amounts added back to calculate EBITDA.