Amortization (business)
Encyclopedia
In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of intangible assets.
. Unlike other repayment models, each repayment installment consists of both principal and interest
. Amortization is chiefly used in loan
repayments (a common example being a mortgage loan
) and in sinking fund
s. Payments are divided into equal amounts for the duration of the loan, making it the simplest repayment model. A greater amount of the payment is applied to interest at the beginning of the amortization schedule
, while more money is applied to principal at the end. Commonly it is known as EMI or Equated Monthly Installment
The amortization calculator
formula is:
or, equivalently,
where: P is the principal amount borrowed, A is the periodic payment, r is the periodic interest rate divided by 100 (annual interest rate also divided by 12 in case of monthly installments), and n is the total number of payments (for a 30-year loan with monthly payments n = 30 × 12 = 360).
Negative amortization
(also called deferred interest) occurs if the payments made do not cover the interest due. The remaining interest owed is added to the outstanding loan balance, making it larger than the original loan amount.
s (often intellectual property
such as patents and trademarks or copyrights) in a systematic manner over their estimated useful economic lives so as to reflect their consumption, expiry, obsolescence or other decline in value as a result of use or the passage of time.
A corresponding concept for tangible assets is depreciation
. Methodologies for allocating amortization to each accounting period are generally the same as for depreciation. However, many intangible assets such as goodwill
or certain brands may be deemed to have an indefinite useful life and are therefore not subject to amortization. However goodwill is subjected to impairment test every year.
Amortization is recorded in the financial statements
of an entity as a reduction in the carrying value
of the intangible asset in the balance sheet
and as an expense in the income statement
.
Under International Financial Reporting Standards
, guidance on accounting for the amortization of intangible assets is contained in IAS 38. Under United States generally accepted accounting principles (GAAP)
, the primary guidance is contained in FAS 142.
While theoretically amortization is used to account for the decreasing value of an intangible asset
over its useful life, in practice, many companies will "amortize" what would otherwise be one-time expenses by listing them as a capital expense on the cash flow statement
and paying off the cost through amortization, thereby improving the company's net income
in the fiscal year or quarter of the expense.
Amortization of loans
In lending, amortization is the distribution of a loan repayment into multiple cash flow installments, as determined by an amortization scheduleAmortization schedule
An amortization schedule is a table detailing each periodic payment on an amortizing loan , as generated by an amortization calculator. Amortization refers to the process of paying off a debt over time through regular payments...
. Unlike other repayment models, each repayment installment consists of both principal and interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
. Amortization is chiefly used in loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
repayments (a common example being a mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
) and in sinking fund
Sinking fund
A sinking fund is a fund established by a government agency or business for the purpose of reducing debt by repaying or purchasing outstanding loans and securities held against the entity. It helps keep the borrower liquid so it can repay the bondholder....
s. Payments are divided into equal amounts for the duration of the loan, making it the simplest repayment model. A greater amount of the payment is applied to interest at the beginning of the amortization schedule
Amortization schedule
An amortization schedule is a table detailing each periodic payment on an amortizing loan , as generated by an amortization calculator. Amortization refers to the process of paying off a debt over time through regular payments...
, while more money is applied to principal at the end. Commonly it is known as EMI or Equated Monthly Installment
The amortization calculator
Amortization calculator
An amortization calculator is used to determine the periodic payment amount due on a loan , based on the amortization process....
formula is:
or, equivalently,
where: P is the principal amount borrowed, A is the periodic payment, r is the periodic interest rate divided by 100 (annual interest rate also divided by 12 in case of monthly installments), and n is the total number of payments (for a 30-year loan with monthly payments n = 30 × 12 = 360).
Negative amortization
Negative amortization
In finance, negative amortization, also known as NegAm, deferred interest or graduated payment mortgage, occurs whenever the loan payment for any period is less than the interest charged over that period so that the outstanding balance of the loan increases...
(also called deferred interest) occurs if the payments made do not cover the interest due. The remaining interest owed is added to the outstanding loan balance, making it larger than the original loan amount.
Amortization of intangible assets
In accounting, amortization refers to expensing the acquisition cost minus the residual value of intangible assetIntangible asset
Intangible assets are defined as identifiable non-monetary assets that cannot be seen, touched or physically measured, which are created through time and/or effort and that are identifiable as a separate asset...
s (often intellectual property
Intellectual property
Intellectual property is a term referring to a number of distinct types of creations of the mind for which a set of exclusive rights are recognized—and the corresponding fields of law...
such as patents and trademarks or copyrights) in a systematic manner over their estimated useful economic lives so as to reflect their consumption, expiry, obsolescence or other decline in value as a result of use or the passage of time.
A corresponding concept for tangible assets is depreciation
Depreciation
Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
. Methodologies for allocating amortization to each accounting period are generally the same as for depreciation. However, many intangible assets such as goodwill
Goodwill (accounting)
Goodwill is an accounting concept meaning the value of an entity over and above the value of its assets. The term was originally used in accounting to express the intangible but quantifiable "prudent value" of an ongoing business beyond its assets, resulting perhaps because the reputation the firm...
or certain brands may be deemed to have an indefinite useful life and are therefore not subject to amortization. However goodwill is subjected to impairment test every year.
Amortization is recorded in the financial statements
Financial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
of an entity as a reduction in the carrying value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
of the intangible asset in the balance sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
and as an expense in the income statement
Income statement
Income statement is a company's financial statement that indicates how the revenue Income statement (also referred to as profit and loss statement (P&L), statement of financial performance, earnings statement, operating statement or statement of operations) is a company's financial statement that...
.
Under International Financial Reporting Standards
International Financial Reporting Standards
International Financial Reporting Standards are principles-based standards, interpretations and the framework adopted by the International Accounting Standards Board ....
, guidance on accounting for the amortization of intangible assets is contained in IAS 38. Under United States generally accepted accounting principles (GAAP)
Generally Accepted Accounting Principles (USA)
In the U.S., Generally Accepted Accounting Principles are accounting rules used to prepare, present, and report financial statements for a wide variety of entities, including publicly traded and privately held companies, non-profit organizations, and governments. The term is usually confined to the...
, the primary guidance is contained in FAS 142.
While theoretically amortization is used to account for the decreasing value of an intangible asset
Intangible asset
Intangible assets are defined as identifiable non-monetary assets that cannot be seen, touched or physically measured, which are created through time and/or effort and that are identifiable as a separate asset...
over its useful life, in practice, many companies will "amortize" what would otherwise be one-time expenses by listing them as a capital expense on the cash flow statement
Cash flow statement
In financial accounting, a cash flow statement, also known as statement of cash flows or funds flow statement, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing...
and paying off the cost through amortization, thereby improving the company's net income
Net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
in the fiscal year or quarter of the expense.
See also
- Amortized analysisAmortized analysisIn computer science, amortized analysis is a method of analyzing algorithms that considers the entire sequence of operations of the program. It allows for the establishment of a worst-case bound for the performance of an algorithm irrespective of the inputs by looking at all of the operations...
- Annuity (finance theory)Annuity (finance theory)The term annuity is used in finance theory to refer to any terminating stream of fixed payments over a specified period of time. This usage is most commonly seen in discussions of finance, usually in connection with the valuation of the stream of payments, taking into account time value of money...
- AppreciationAppreciationIn accounting, appreciation of an asset is an increase in its value. In this sense it is the reverse of depreciation, which measures the fall in value of assets over their normal life-time...
- Depletion (accounting)
- DepreciationDepreciationDepreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used ....
- EBITDAEBITDAEBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. It is a non-GAAP metric that is measured exactly as stated. All interest, tax, depreciation and amortization entries in the income statement are reversed out from the bottom-line net income...
- List of real estate topics
External links
- Amortization at Wikinvest
- Amortization Formula and Calculator at Math Major
- Downloadable Equated Monthly Installment (Amortization) Calculator by Atul Nene - free and open source.