If you’re preparing or reading corporate financial information, investing, or looking for investors yourself for your own business, you need to know a bit about amortization.
Amortization is a financial accounting term, which you’ll often see alongside depreciation when analysts and companies talk about business performance. This guide covers all you need to know about amortization, why it matters – and how it’s different to depreciation.
What is Amortization?
Amortization refers to the accounting practise in which the cost of a loan or intangible asset is spread over time. This can help businesses present a clearer picture of their financial health.
Let’s say, for example, you take a business loan in a given year. If you show the full cost of the loan in the year it’s received, it will put a significant dent in the profits you can report for that financial year. It also doesn’t really represent how business loans are normally used or paid for. Instead, using amortization you can spread the cost of the loan in your financial statements over the loan’s period. This helps to give a more realistic picture of how the charge is being absorbed over a long period, rather than it looking like the costs come in one big hit.
In the US, the rules covering how amortization can be used in company accounts are set and regulated by the Financial Accounting Standards Board (FASB). You can get full guidance for the reporting standards applied, online on the FASB website.
You’ll often see amortization alongside its close cousin depreciation. We’ll cover the difference between these two accounting terms, later.
Amortization of loans
Amortization is usually used to refer to loans, or intangible assets. In the case of loans, you can see the way amortization works by looking at an amortization schedule. In fact, you may have seen one before if you’ve ever taken a mortgage for example.
Each loan repayment made will go towards covering both the interest to be paid on the loan, and the capital amount that was borrowed. Over time the absolute amount you pay every month will remain the same, but you’ll gradually start to repay more and more of the capital as the interest due reduces.
This process can be reflected in company accounts so that the costs of a loan are spread out over a realistic time scale instead of appearing on a financial statement as a single item.
Amortization of assets
Amortization of assets in an accounting sense usually refers to intangible assets, such as goodwill, trademarks, patents and human capital. If there is a cost attached to these assets it can be amortized in the same way a loan can be.
To give an example, if a business buys a startup in order to access its people or technology, it may be willing to pay over market value to do so. The difference between market value and the actual price paid may then be represented as goodwill in the company accounts, and spread out over a number of years to lessen the immediate impact on the profitability of the business.
It’s worth noting that there are strict guidelines in place about how amortization can be applied. Make sure you and your team understand these if you’re preparing your own financial statements.
How Amortization Works
Amortization of loans works in a similar way for homeowners who take a mortgage and businesses who choose to amortize a loan in their financial accounts. Let’s work through an example.
When you take a loan you get a sum of money, with an agreed repayment schedule and interest rate. Repayments are made on a regular basis, say every month, and are normally of equal value. Over time, though, your monthly payments will be applied in different proportions to repay both the interest and the capital amount of the loan.
At first there’s a lot of interest to repay because the loan amount is at its largest. However, the more capital you pay down, the less interest there is to cover. By the end of your loan term you’ll mainly be paying the capital amount with smaller and smaller amounts of your repayment going towards interest.
Amortization of intangible assets follows similar principles – albeit in a way that’s slightly more complicated to visualize. If a company secures a new patent, for example, this may increase the value of the company. However, there are also costs associated with this intangible asset, and amortizing these allows the business to spread the impact over a longer period.
Why is amortization important?
Amortization is used in accounting to help businesses, analysts and investors to understand the costs of intangible assets, and forecast the financial results of a business over time.
Sometimes, analysts and business owners don’t want to see the impact of amortization when looking at the financial status of a company. This can be because amortization is a long term measure, and what’s needed is a snapshot of the company’s ability to deliver a profit in a shorter period. In this case may see other measures being used such as EBITDA – earnings before interest, tax, depreciation and amortization.
How to calculate amortization?
The way you calculate amortization will depend on the situation. If you’re looking from a personal perspective – to see how your mortgage payments will amortize over time, for example – you can find helpful tools such as amortization schedules and calculators online. These will help you to split out the portion of your payment month by month which goes to interest, and how much goes towards paying down the capital loan.
If you’re calculating amortization for your company balance sheet the basic principles are similar, but the rules which govern reporting are set by the regulatory authorities in your region. The rules used vary under GAAP (Generally Accepted Accounting Principles) which is the US standard, and IFRS (International Financial Reporting Standards) which is used in Europe, and parts of Asia and South America.
There’s lots of information and advice online about how to calculate amortization for different asset types – but professional advice is essential if you’re unsure.
Amortization vs depreciation
You’ll often hear the terms amortization and depreciation used side by side. They are similar concepts, but while amortization is used for intangible assets, depreciation is applied to tangible things like equipment or vehicles.
Amortization as an accounting concept can be fairly complex. But it can be an important aspect of your company balance sheet if you’re dealing with intangible assets like loans, patents and trademarks. This guide gives you all the basics you need to understand how amortization works – learn more with further research, and get professional, tailored support if you need it.