Amortization Meaning Simply Explained

Amortization is an accounting method used over a certain period to gradually lower the book value of a loan or other intangible asset. The amortization of a loan focuses on deferring loan payments over some time. Also, amortization is comparable to depreciation in terms of how it affects an asset’s valuation.

Main takeaways

• The process of value reduction for a debt or an intangible asset is known as amortization.
• Lenders, including financial institutions, utilize amortization plans to show a loan payback schedule based on a specific maturity date.
• Intangibles are amortized (expensed) over time as per the GAAP matching principle, which links the asset's cost to the revenues it generates.
• When loan payments are less than the accrued interest, negative amortization may occur, which increases the amount owed by the borrower.
• Most accounting and spreadsheet programs provide tools for automatically calculating amortization.

Learn more about The best accounting software in Saudi Arabia.

Getting To Know the Amortization Process

Two scenarios are described by the term "amortization." First, amortization is used in repaying debt over time with consistent principal and interest payments. An amortization plan is used through periodic charges to lower the outstanding balance on loans, such as a mortgage or a vehicle loan.

Second, amortization may also refer to the technique of distributing capital costs associated with intangible assets over a predetermined period, often during the asset's useful life.

Loan Amortization

Amortization refers to the process of repaying a loan in full by the maturity date by making monthly payments of the principal and interest over time. Early in the loan's life, a more significant portion of the flat monthly payment goes toward interest, but with each subsequent payment, a larger part of it goes toward the loan's principal.

Most contemporary financial calculators, spreadsheet programs (like Microsoft Excel), and online amortization calculators may all be used to calculate amortization. In addition, the lender may offer a copy of the amortization plan or, at the very least, specify the loan length for which payments are required when entering into a loan arrangement. ​

How To Amortize Intangible Assets?

In this context, amortization refers to depreciating an intangible asset's cost over the asset's anticipated life. It quantifies the depletion of an intangible asset's valuation, such as goodwill, a patent, a trademark, or a copyright.

Amortization is calculated similarly to depreciation, used for natural resources, and depletion, used for tangible assets, such as machinery, buildings, automobiles, and other assets susceptible to physical wear and tear.

According to generally accepted accounting principles (GAAP), when firms amortize expenditures over time, they help link the cost of utilizing an asset to the income it generates in the same accounting period. For instance, a business gains for years from using a long-term asset, thus, it deducts the amount gradually over the asset's useful life.

Tax planning might benefit from intangibles' amortization. Taxpayers are permitted to deduct certain costs, including geological and geophysical costs incurred in oil and natural gas exploration, facilities for controlling air pollution, bond premiums, research and development (R&D), lease acquisition, forestation and reforestation, and intangibles like goodwill, patents, copyrights, and trademarks. (According to the applicable laws)

The Importance of Amortization

Amortization is crucial since it aids in the understanding and long-term forecasting of expenses for organizations and investors. An amortization schedule clarifies how much of a loan payment is made up of principal versus interest in the context of loan repayment.

This can be helpful for things like tax deductions for interest payments. Understanding a company's upcoming debt amount after several payments have been made helps prepare for the future.

Amortizing intangible assets is crucial because it may lower a company's taxable income and, thus, its tax bill while providing investors with a clearer picture of the business's actual profitability.

The useful life of intangible assets is similarly limited; with time, patents or trademarks may become obsolete and lose value. Amortizing intangible assets also shows how much asset value a corporation has "used up."

Questions and Answers

Why Does Accounting Need to Consider Amortization?

With amortization, businesses and investors may better understand and predict their expenses over time. An amortization schedule clarifies how much of a loan payment is made up of principal versus interest in the context of loan repayment. All this can be helpful for things like tax deductions for interest payments. Intangible asset amortization is crucial because it may lower a company's taxable income and, thus, its tax bill while also providing investors with a more accurate picture of the company's genuine profitability.

How Is a Loan Amortized?

Calculating the monthly payment due throughout the loan's life is how a loan is amortized. The next step is to create an amortization plan that specifies exactly what portion of each monthly payment goes toward the principal and what goes toward interest. The monthly interest will decrease since a portion of the payment will presumably be used to reduce the remaining principal debt. In addition, since your payment should ideally remain constant each month, more of it will go toward the principal each month, thereby reducing the amount you borrowed.

The Conclusion

A method of progressively lowering an account balance over time is called amortization. A steadily increasing part of the debt payment is applied to the principal each month while loans are amortized. Like depreciation, amortization of intangible assets involves taking a specified percentage of the asset's book value off each month. This method is used to demonstrate how a corporation benefits from an asset over time.