The term amortization is best known in reference to paying off bank loans or other debt with a series of regular payments. The paid off loan is said to be amortized. The term also applies, however, to reducing the book value of intangible assets wtih a series of regular non-cash expenses
The term amortization is used in business in at least two ways. Both refer to making regular payments over a period of time. Amortization may refer to a stream of payments that accomplish either of the following:
- Reduce the book value of intangible assets.
- Payoff loans or other debt.
It is interesting that the English word amortization has etymological roots in Middle English, Old French, and Latin words for "to kill" or "death" (mortem is "death" in Latin, for instance). It is not inappropriate to say that amortization "kills off" the loan or the asset value.
Explaining Amortization in Context
This article further defines and illustrates amortization and related terms as they appear in financial accounting and business generally. Terns such as the following have to do especially with the value of assets:
- What is amortization? Two different meanings in business.
- What is the meaning of amortization when referring to intangible assets?
- Amortization as loan payoff or debt retirement.
Amortization refers to the accounting procedure that gradually reduces the book value(carrying value) of an intangible asset, over time, just as depreciation expenses reduce the book value of tangible assets. Asset amortization—like depreciation—is a non-cash expense that reduces reported income and thus creates a tax savings for owners.
What Are the Major Intangible Asset Categories?
Accounting practice recognizes intangible assets as physical assets, with an expected usage life of a year or more. Different kinds of intantible assets may be named generally as goodwill or intellectual property, or more specifically such as the value of brand name, artistic assets, franchise holdings, good customer relationships, a customer list, purchased use of patent rights, or the company's own proprietary technology. Intangible assets are further described as being either indefinite or definite:
- For Indefinite intangible assets, ownership is expected as long as the company is in business. For indefinite intangibles, there is no "end of life" in view. Indefinite intangibles generally cannot be amortized, although accountants are encouraged to re-evaluate the asset's indefinite nature from time to time.
- Definite intangle assets, however, are meant to be held for a limited time period, or else they have a service life or economic life with a definite end in view. Definite intangible assets are eligable for amortization.
How is Value Assigned to Intangible Assets?
The value of intangible assets in private industry can be very real and very large (see the articleBranding, for instance). The company's accountants may be challenged, however, when trying to set the initial book value and amortizable life of intangible assets. The US Financial Accounting Standards Board (FASB) and comparable authorities in other countries provide detailed and specific guidance in this regard (e.g., FASB 141), which may refer to factors such as the recorded cost of purchased intangibles, expected impact on income, or the likely cost of creating another intangible asset of equal value today. Ultimately, however, these value judgments inevitably include a subjective component.
How are Intangible Assets Amortized in Accounting?
Amortization of (definite) assets in this sense in this sense is almost always applied using the straight line method. For a definite asset with a 10-year life, for instance, the amortization expense each year would be one-tenth of its initial amortizable value. The timing and rates of amortization expenses charged are called the amortization schedule (rather than depreciation schedule).
Amortization expenses appear on financial statements in a manner similar to that used for depreciation expenses.
- Amortization appears on the Income Statement as an expense, like depreciation expense, usually under Operating Expenses, (or "Selling, General and Administrative Expenses).
- Amortization appears on the Balance sheet, accumulating from year to year to reduce asset book value, just as accumulated depreciation reduces the book value of tangible assets.
- Amortization is a non-cash expense but it nevertheless impacts the Statement of changes in financial position SCFP (Cash flow statement).
Under SCFP "Sources of Cash-Operating Activities," non-cash expenses including amortization and depreciation are "added back," (i.e., subtracted), so that the remaining total for Operating Activities represents only real cash inflow.
For tangible assets, depreciable value is usually taken as the recorded cost less residual value. Definite intangible assets, however, are usually regarded as having no residual value, and so depreciable value is normally taken as the full book value. For definite intangibles purchased for use over a limited time period (e.g., usage of patent rights) usage life is taken as amortizable life. For other definite intangibles, however, amortizable life may be taken as the expected service life oreconomic life of the asset.
The term amortization is best known as a reference to paying off a debt with regular payments (as in "amortizing" a mortgage, or "loan amortization"). When amortization is used in this sense, the debt payoff schedule may be called the amortization schedule.
What is the Nature of Amortization Payments?
Amortization payments for loan payoff or debt retirement have two characteristics:
- Payments are "regular," i.e., they are paid at regular intervals and all payments are the same (except sometimes for the final payment, which is slightly different from the other payments, so as to make the series of payments exactly cover what is due for interest and principal.
- Each payment covers interest due on the outstanding balance since the previous payment, and then retires a component of the outstanding balance.
How are Amortization Payments Calculated?
The primary amortization calculation of interest to lenders and borrowers has to do with finding the periodic payment amount due, so that the above two characteristics are met. Lender and buyer approach this caculation already knowing the following:
P = principal, or the amount borrowed.
i = interest rate per period. For instance, when the annual interest rate is 8% and the number of periods per year is 12, then i = 6% / 12 = 0.5%.
n = the number of periods, or the total number of periodic payments to be made.
For instance, an individual might approach the bank asking for a 5-year $25,000 loan to purchase an automobile, when the annual interest rate for borrowing is 6.0%. If the loan is to to be set up with monthly payments, P, i, and n are as follows:
P = $25,000
i = 6% per yr / 12 payments per yr = 0.5% per payment period (month).
n = 5 Years * 12 payments per annum = 60
Conventional use designates the symbol A as the monthly payment amount to be found. This is because the payment stream is—to the lender—an annuity. The formula for payment amount (A) using the symbols above is written in various ways, but the most easily implemented form is this:
A= (P * i) / (1 - (1+ i)^-n
The borrower or lender wishing to find A from given starting values for P, i, and n, can turn to any of the many free "Loan Calculators" or "Amortiztation calculators" to be found on the internet. For the individual wishing to try out many different possible data sets, however, or to produce a loan payoff table (such as the example in the next section), it may be preferable to implement the formula in a spreadsheet of your own. To implement this formula in an MS Excel spreadsheet, for example, it is helpful to set up first a small table in the spreadsheet, putting the values for i, P, and n in the right most column:
A small table created to facilitate calculation of A, the amortization periodic payment. Value cells in the right column are given names shown in the center column.
Then, assign names to the right-column value cells, using labels such as those shown in the center column (Value Cell Name). Then the Payment formula for A, above, can be written in Excel, as:
= ( principal * interest) / (1 - ( 1 + interest )^-number)
Using the given example values, the monthly payment A is $483.32.
How is Loan Payoff Summarized in an Amortization Table (Loan Payoff Table)?
During the life of an amortized loan, borrowers may refer to a loan payoff table (loan amortization table), such as the following:
Beginning and ending rows of a loan payoff table for the 60-month loan example above. The full table includes 60 rows, one for each payment.
The payoff table shows the progress of loan repayment after each periodic payment. Specifically, the table shows
- How much of each payment pays for the period's interest.
- How much of each payment pays for reducing the balnce due on the principal.
- The remaining principal balance due after each periodic payment.
Such a table is of high interest to borrowers who may wish to payoff the loan completely at some point before the final period.