Amortization

Amortization is an accounting method to lower the book value of a loan or intangible asset. Learn about the amortization definition, what an amortization schedule is, and how a business should correctly amortize debt or intangibles.

What is Amortization?


Amortization is an accounting method to lower the book value of a loan or intangible asset over its useful life. The amortization process touches both the balance sheet and income statement.

When an intangible asset is purchased, the item is added to the balance sheet as an account. Over the useful life, the value of the intangible asset is reduced through the process of amortization.

The amount of amortization in a given period is recorded as amortization expense (a non-cash activity) on the profit and loss statement.

A similar process happens for the amortization of a loan as payments are made. Amortizing an intangible asset or loan is similar to the depreciation process.
Both amortization and depreciation show a decrease in the economic value of items, but they are not actual cash outflows. For instance, a $10,000 depreciation expense shows up on the income statement as an expenditure but you did not pay $10,000 to anyone.

These non-cash expenditures influence a company’s profitability and taxes due.


How to Calculate Amortization


It’s important to have the correct book value for loans and intangible assets, like trademarks, copyrights, patents, and goodwill. That makes calculating amortization important for accounting and finance managers.

In order to start the amortization process, you will need:

  • Starting value in dollars
  • Ending value in dollars (also called residual or salvage value)
  • Useful life expressed in number of years
  • Total amortization expense

Here is the straight line amortization formula:


Amortization Expense = (Book Value - Residual Value) / Useful Life


There are other amortization methods that may be used in particular situations.


Amortization of Intangible Asset


This is an example of amortization for an intangible asset.

Intangible assets will lose value over time, so they should be amortized.

For example, Company A purchased a patent portfolio for $1,000,000. The portfolio has a residual value of $100,000 and a useful life of 5 years. Let’s look at the amortization expense, carrying value, and accumulated amortization using a straight line method.


Company A Patent Portfolio

  • Book Value: $1,000,000
  • Residual Value: $100,000
  • Useful Life: 5 years

Here is how we calculate the amortization expense:


Amortization = (Book Value - Residual Value) / Useful Life

Amortization = ($1,000,000 - $100,000) / 5 years

Amortization = $900,000 / 5 years

Amortization = $180,000 per year


The amortization of assets is important to make sure that the utility of the asset and their book balance on the balance sheet match. For instance, a company might undergo a rebranding and their old trademarks might have significantly less utility and value going forward.

The process for tangible assets is similar, although tangible assets are depreciated instead of amortized.

Amortization of Loan


The process is similar for loan repayment. This is an example of amortization for a loan.

Company A borrows $500,000 from a lender. The loan term is 6 years and the annual interest rate is 6.0%. Payments are made on a monthly basis. Let’s break down how the loan will be repaid.


Company A Loan

  • Principal Amount: $500,000
  • Annual Interest Rate: 6.0%
  • Number of Years: 6

The loan payment formula is:


Payment = r(PV) / 1 - (1 + r)^-n


Where PV = present value, r = rate per period, and n = number of periods.

Since we are given an annual interest rate and monthly payments, we need to convert everything to monthly values. A 6% annual interest rate becomes 0.5% monthly interest rate. Similarly, 6 years needs to be translated into 72 months.

Present value simply refers to the loan value at the start of the period.


Here is the math:


Payment = 0.005(500,000) / 1 - (1 + 0.005)^-72

Payment = 2,500 / 1 - (1.005)^-72

Payment = 2,500 / 1 - 0.6983

Payment = 2,500 / 0.3017

Payment = $8,286


If Company A made 72 monthly payments of $8,286, they would pay back $596,592. $500,000 is principal and $96,592 is interest.

Note that there might be small changes in monthly payments and total payoff due to where you round the intermediary steps.


Amortization Schedule


An amortization schedule is a helpful tool to track how the value of an intangible asset or loan has changed over its life. Amortization schedules for intangible assets have information about the cost of the intangible asset, useful life, and value every year.
Amortization schedules for loans are a little more involved, as we want to track the value of the loan every month. These schedules include the original loan amount (principal), monthly interest rate, monthly payments, number of payments, and loan balance after each payment.

Amortization Schedule for Loan


An amortization schedule for a loan is a table that features all of the relevant information for the borrowing. Information such as the amount borrowed, the interest rate, the number of periods, and the payment amount are listed.

In most cases, the outstanding balance of the loan is repaid over several years. Periodic payments from the borrower to the lender are made – in most cases, these payments are made monthly.

Even if a loan has a fixed monthly payment, the amount of principal and interest will vary with every payment made. At the beginning of a loan, interest is at its highest. As payments are made, you will pay less and less interest every month.

The final loan payment will pay off the debt in full.

Here are the columns that you would expect to see:

  • Loan amount (principal)
  • Annual interest rate
  • Monthly interest rate
  • Number of payments
  • Dollar value of monthly payment
  • Total accumulated interest

Amortization Schedule for Intangible Assets


The amortization process for an intangible asset can be more tricky. First, intangible assets could have a finite life or an infinite life.

If the asset has an infinite life, it is not amortized every year. Instead, it is tested in regular intervals for impairment. Impairment checks that the current book value reflects its actual economic value.

If the asset has a finite life, it could be amortized based on its contribution to revenue or in a straight line method. We used straight line amortization in our example above.


Non-Cash Expenses


The profit and loss statement records all revenues and expenses in a given accounting period in order to arrive at a net income or net loss amount. That said, not all of the transactions impact cash.

Non-cash expenses refer to expenditures that do not actually require a cash outflow. The most common examples are depreciation and amortization.

For example, the value of a piece of machinery will decrease with its use. Equipment that costs $1,000,000 will slowly degrade over time. This degradation is shown as depreciation expense, which is reported on the income statement and lowers a company profit.

However, $50,000 of depreciation expense does not mean the company paid $50,000. Instead, it refers to the decreased value of the asset.

In order to work around these non-cash activities, analysts have started to look at earnings before interest, taxes, depreciation, and amortization (EBITDA) as a key profitability metric.


Final Thoughts


Amortization is an accounting method to lower the book value of a loan or intangible asset over a period of time. This treatment applies to the repayment of personal loans, auto loans, mortgages, and more. For our purposes, we discuss a business amortizing a loan or intangible asset.
The amortization of intangible assets occurs to reflect a change in their book value. For instance, as a patent is used and comes closer to its expiration date, it becomes less valuable.
The amortization of loans shows the outstanding debt balance after regular payments are made. For example, the amount of principal left changes after every monthly mortgage payment is made for a family.

Amortization has a direct impact on multiple financial statements and impacts a company’s taxes due. Similar to depreciation, the Internal Revenue Service (IRS) has guidelines on how to amortize items for accounting and tax purposes.

Companies often use spreadsheets or financial software to keep track of their amortization. In addition, an amortization schedule is a useful tool to keep track of your different assets, loans, interest rates, and formulas.

Business owners, managers, lenders, and analysts all look to amortization when trying to understand the financial health of a business. This is because depreciation and amortization will reduce a company’s profitability and thus their tax liability.

Many lenders and analysts will look at EBITDA (which excludes non-cash expenditures) to get a more accurate view of the underlying business operations.

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