Amortization is paying off an amount owed over time by making planned, incremental payments of principal and interest. To amortize a loan means "to kill it off". In accounting, amortization refers to charging or writing off an intangible asset's cost as an operational expense over its estimated useful life to reduce a company's taxable income.
Amortization has two connotations. The term refers to payment of loan over a particular period of time. Moreover, the term denotes spreading the capital expenditures incurred on intangible assets, which include brand name, patent, copyrights, trademarks, goodwill, etc. over a specific time period. The cost is allocated for tax and accounting purposes.
Explanation of the Term Amortization
Amortization, when it comes to loan payment means regular payment of a loan in installments using a fixed repayment schedule. Mostly amortization is applied to car and mortgage loan. Usually the monthly payment is composed of interest during the beginning of the schedule. The proportion of principal amount increases with each subsequent payment.
For instance, on a home that is bought on a 30-year, $120,000 mortgage at 5% interest rate, the first monthly payment would be $663 of which the principal amount would be $138 while the remaining $525 will be interest payment. The last installment would be $2,651 of which $2,622 would be the principal amount and $29 interest payment.
Amortization has an entirely different connotation when it is used for accounting of intangible assets. The term is similar to the concept of depreciation and depletion that is applicable for tangible assets and natural resources, respectively. It simply refers to allocation of expenses incurred on an intangible asset in a way that it matches the revenues incurred by the asset.
Suppose that ABC pharmaceutical company has spent an amount of $40 million on a drug patent that will be valid for 14 years. The company will not record the entire amount in a particular period. Instead, the company will spread the amount over a period of 15 years. This way the company will record $2.85 million as amortization expenses in its accounts. This technique of spreading the cost incurred in a patent over a specific time period is known as amortization.
In the US, IRS allows companies to deduct expenses incurred on the following as amortization expenses.
- Research and development,
- Lease purchase,
- Geologic and Geophysical Expenses,
- Forestation and Reforestation,
- Intangible assets (copyrights, patents, goodwill, and trademarks).
Amortization can be calculated using online calculators, financial calculators and spreadsheet applications such as Microsoft Excel.