What is amortization?
Amortization is an accounting technique used to spread the value of the asset or loan principal over time.
(learn more about company assets and asset classifications here)
For businesses, depreciation is an accounting method used to “expense” or spread out the cost or value of a intangible asset, such as intellectual property or goodwill. The associated tool for fixed assetssuch as buildings or equipment, is depreciation.
There are different techniques for calculating amortization and depreciation and there are industry guidelines in FAS section 142 of Generally Accepted Accounting Principles (GAAP).
For personal finance, an example of amortization is determining fixed mortgage payments that are designed to completely pay off a mortgage in 15 or 30 years, for example.
What is a depreciation charge?
A depreciation expense is an item that appears in a company’s financial statements as a result of the depreciation of an asset. The amortization of an intangible asset is presented as an expense (ie a “write-off”) in a company’s income statement. This charge reduces the residual value of the asset carried on the company’s account balance sheet over time, and is charged to business expenses income statement.
Amortization versus depreciation
Applied to assets, depreciation and depreciation are similar concepts in that both are used to expense an asset over time. The main difference is that depreciation applies to tangible assets while amortization applies to intangible assets. Fixed assets include buildings, equipment or other physical assets that are subject to wear and tear or obsolescence over time. Intangible assets are non-physical assets such as trademarks and copyrights.
There are also differences in how the two are presented in financial statements and how they are calculated. Depreciation is shown by directly crediting (reducing) the specific asset account. Depreciation, on the other hand, is shown by crediting a separate account called “accumulated depreciation”.
Finally, everyone’s calculation may be different. Intangible assets are often amortized over their useful life using the straight-line method, while fixed assets often use a much broader set of calculation methods, such as declining balance, double declining balance, sum of digits years, or production method units.
What is goodwill?
Goodwill is a unique asset of the company. It is an intangible asset that is only created when a business is acquired. The cost of buying a business beyond that associated with identifiable assets is collectively considered goodwill. Goodwill can include the collective value of a company’s brand, customer relationships, artistic or intellectual assets, and proprietary technology or patents.
When a company is acquired, the suitor pays a specified value which will generally be greater than the net asset value of the target company to induce shareholders to sell. If the net assets of the target company are $80 million and the suitor acquires it for $100 million, the additional $20 million paid is deemed to represent “purchase consideration” or a spread of acquisition and are then classified as an intangible asset on the claimant’s balance sheet.
The significance of goodwill from an amortization perspective is that under current US GAAP and IFRS accounting rules, goodwill is considered to have an indefinite useful life and therefore cannot be amortized in public companies. . There is, however, an exception to this rule for private companies, which may choose to amortize goodwill over a period of ten years or less under an accounting alternative from the FASB’s Private Company Council.
What is an amortization schedule?
An amortization schedule describes how much of an asset’s value (or loan principal) is amortized over time, showing the amount of amortization for each relevant period.
Loans can be amortized using different methodologies. A loan with constant damping would simply take the total principal amount and divide it equally over each scheduled payment period. But the interest payment would vary each month as the remaining balance would decrease, making the payments different each month and quite high at first.
For mortgages, homeowners overwhelmingly prefer a fixed mortgage payment each month to blend in with their income. Thus, for a standard mortgage, banks use a constant payment instead, which results in a fixed loan payment in which the shares of interest and amortized principal vary with each payment.
An amortization schedule for most mortgages would therefore take the form of a schedule showing the amount of principal that is amortized each month over the life of the loan. Using the amortization schedule, a person can see the total amount of principal that has been paid (or remains) at any point in the life of the loan. (There are also ways to use a calculator or computer spreadsheet to calculate the amount of depreciation for a given month.)
How to Calculate Depreciation
The calculation of the amortization amount of a loan or asset (i.e. the amount of principal paid over a given period) depends on the amortization method used.
Using “constant amortization”, one would simply divide the principal total by the number of periods desired. For example, a $360,000 mortgage to be repaid monthly over 30 years would require a principal payment of $1,000 each month (30 x 12 x $1,000 = $360,000) to be fully amortized. Interest payments would be added to this. The depreciation formula would be as follows:
To determine the cumulative amortization at any point in the term of the loan (i.e. how much principal has been paid off up to that point), simply multiply the number above by the number months the loan has been in place. After 15 months, $15,000 of principal will have been paid and therefore $345,000 of principal will remain.
For a constant repayment loan, the amortization is usually presented in a table such as the one below. The procedure for completing it is as follows:
- Enter the initial loan balance for month 1 (column A)
- Enter full amortization payment (calculated separately from loan amount, interest rate and loan term) (B)
- Enter the monthly interest due on the current loan balance (C=A*.05/12)
- Determine the damping (Column D = B – C)
- Calculate the ending loan balance for the period (Column E = A – D)
- Carry forward the ending balance to the next month as a new beginning balance (A = E from previous month)
- Repeat for the entire term of the loan
Hypotheses:
Capital borrowed = $360,000
Interest rate = 5% annually
Fixed monthly payment to fully amortize = $1932.56
Month |
Original loan balance^{A} |
Monthly payment^{B} |
Interest^{VS} |
Amortization^{D} |
End of loan balance^{E} |
1 |
$360,000 |
$1932.56 |
$1,500 |
$432.56 |
$359,567 |
2 |
359,567 |
1932.56 |
$1,498 |
434.36 |
359 133 |
3 |
359 133 |
1932.56 |
$1,496 |
436.17 |
358,697 |
4 |
358,697 |
1932.56 |
$1,495 |
437.99 |
358 259 |
5 |
358 259 |
1932.56 |
$1,493 |
439.81 |
357,819 |
6 |
357,819 |
1932.56 |
$1,491 |
441.65 |
357 377 |
… |
… |
… |
… |
… |
… |
360 |
1924 |
1932.56 |
8.01 |
1924.55 |
0 |
What is negative amortization?
Loan amortization is generally designed to reduce the loan balance each period until it reaches zero and the balance is fully paid off. For each payment period, the amortization amount is paid and the remaining balance on the loan is reduced. In this way, positive amortization of a loan reduces the principal balance each period.
If the principal balance is not reduced enough each month, it will not reach zero at the end of the loan term. This scenario results in “partial amortization”.
If the principal balance is not reduced at all each month, it will be the same at the end of the term of the loan as at the beginning. This scenario occurs with an “interest only” loan. A borrower pays interest on the outstanding balance each month and is then required to repay the principal in a lump sum at the end of the loan. (These payments are called “lump sum payments”.)
If the principal balance increases, it causes “negative amortization”. This would not be how a bank would offer a loan to a borrower and instead would occur when a borrower fails to make a payment. If no payments are made on a fixed payment mortgage, no scheduled amortization occurs and no interest is paid. In this case, the lender would typically add accrued interest to the loan balance.
Thus, instead of the outstanding principal balance decreasing, it is increased by unpaid interest. This results in negative damping. Lenders don’t want negative amortization and will likely consider the borrower to be in default if it persists.
Is depreciation included in cash flow?
No. For businesses, depreciation and amortization are non-cash accounting items. Additionally, they may be calculated differently by different companies, obscuring comparisons between one company’s fundamentals and another’s.
On a company’s income statement, depreciation and amortization will be listed as expenses. However, the corresponding amounts are generally added back to net income when calculating a company’s profitability. Cash flow of operations (CFO).
Example of depreciation
For a loan, the amortization can be total, partial, nil (interest only) or negative. The table below uses the example mortgage loan above to illustrate the different types and show what the loan balance would be in each scenario.
Loan principal = $360,000
Duration = 30 years
Interest rate = 5% (fixed)
Payments = monthly
Type of damping |
Monthly payment |
Loan balance in 30 years |
Full |
$1932.56 |
0 |
Zero (interest only) |
$1500 |
$360,000 |
Partiel |
Between $1500 and $1932.56 |
Between 0 and $360,000 |
Negative |
Payment |
> $360,000 |
Conclusion
Amortization is a mechanism that can apply to both business and personal finance. For businesses, amortization is an expense charged to intangible assets, in the same way that amortization is an expense charged to tangible assets. Depreciation and amortization are non-cash charges charged to a company’s income statement.