Amortization is an accounting method that is used to reduce the book value of both debt and assets over a specified period of time. When referring to debt, it is simply the repayment of debt. Some common methods are the straight-line method, the fixed-rate method, the effective interest rate method, and the bullet and balloon methods. In regards to debt, it is a way to track future expenditures and create a method of repayment. It makes it easy for companies to track when their debt needs to be repaid and how much of it is still outstanding. Since it is deductible from a company's taxes, it is an extremely valuable tool.
This method is used for both debt and assets but differs from depreciation in its application. Depreciation is only used when reducing the book value of tangible assets (plants, property, equipment, etc.) while amortisation, on the other hand, only refers to expensing out the loss in value of intangible assets (patents, contracts, trademarks, etc.). In regard to assets, it allows companies to keep track of how much an asset is worth, how much longer it is useful, and whether it is written down as an expense, which decreases taxes for the company. It can be found both on a company's Income Statement and on the Cash Flow Statement. While separate terms, depreciation, and amortisation are usually coupled as they are both considered non-cash expenses. It may also be recorded in a company's general ledger as a contra account. While general ledger accounts may not be publicly reported by a company, investors can use this data within the Income Statement and Cash Flow Statement to learn more about a company's debt obligations. It is an important concept because it is helpful for keeping track of payments and debt balances as well as valuing intangible assets, and for investors looking to understand a company's financials better. Many must create a repayment plan to pay off their mortgages, which is covered below.
Amortization of loans
Amortizing debt simply mean its repayment, where the type refers to the method of repayment. It keeps track of the rate at which the debtor pays both the interest and the principal, which together make up an installment (the total payment made towards the debt balance).
The principal portion of the installment goes towards paying off the face value of the loan, and the interest is the extra money charged to compensate for both the risk of lending and the time value of the money lent. Interest rates are annual rates which means that they do not refer to the interest paid over the entire course of the loan, nor do they refer to the interest paid on each installment. Instead, they refer to the interest paid each year. In many instances, interest payments decrease over the life of the loan, as it is charged only on the outstanding balance.
It is used in every case where debt is paid off. It is extremely common for companies to pay off premiums or discounts on bonds, loans, notes, and other types of debt instruments. People often pay off loans such as home mortgages, car loans, and credit card debt.
The way in which the debt is paid depends on the type of loan and the method being applied. It keeps track of the repayment of debt so that it is easy to understand when it needs to be repaid, how much is owed, how much is paid, and how much of each payment is allocated to principal repayments and interest charges. Hence, it is important to understand this in order to have a better idea of debt and how it may be paid off.
Amortization of intangible assets
Amortization is used most commonly in reference to debt repayment, but that is not its only use. It can also apply to assets, however, it differs from depreciation in that it only applies to intangible assets, while depreciation applies to tangible assets such as plants, properties, and equipment. Intangible assets are assets like patents, trademarks, or copyrights that decline in value throughout their life and have to be expensed periodically over their useful life. Intangible assets usually refer to documents, brand value, or know-hows that represent intellectual property.
The effect of this process is most visible when dealing with tax returns as they are a tax-deductible expense. Most intangible assets are required to have their value reduced over a period of 15 years because in many cases intangibles do not have a definite useful life, and so the Internal Revenue Service (IRS) requires many to be deducted within this period. Although, many intangible assets do have a definite useful life, but are required to be expensed within 15 years regardless. While most intangible assets by far are subject to this regulation, there are a few exceptions. Often intangible assets are reduced through the straight-line method.
Let's understand this better with the help of an example. Let's assume that a company Bananas Ltd. owns a patent that is valid for 10 years and is worth $20 million. At the end of 10 years, this patent will expire and would be considered worthless. The annual expense relating to expensing this patent would be $ 2 million ($20 million / 10 years).
This expense is found both on the Income Statement and the Cash Flow Statement. Expensing off asset balances is most useful for a company that deducts the expense from its taxable income.
Amortization vs Depreciation
The difference between amortization and depreciation is quite simple. While the former is used to track the decrease in the value of intangible assets and of debt, the latter is used to track the decrease in the value of tangible assets.
Some tangible assets, such as land, do not depreciate, but companies often have equipment that becomes less useful over time. The period over which a tangible asset can be used is called its useful life. At the end of an asset's useful life, there may still be some value which is called its residual value and companies can choose to discard an asset or sell it to another firm. In some cases, a company may even continue to use an asset past the end of its useful life or recalculate an asset's useful life if it depreciates slower than originally estimated.
Depreciation is calculated similarly to amortisation and has multiple methods of how it may be applied to tangible assets. However, because tangible assets are used over a quantifiable period of time, a company may choose to calculate depreciation by its machine hour rate, meaning how much a machine depreciates within a span of one hour of usage. This method can be useful because it takes into account that a machine may not be used the same amount every year.
An example of depreciation is if a company were to buy a truck for $65,000. The company estimates how much the truck will be used each year and how long it is likely to be useful. In this example imagine the company finds that it will depreciate $5,000 each year and it has a residual value of $15,000. After 10 years the truck will depreciate to its residual value and the company will either sell it or discard the truck. The truck may not necessarily sell for exactly the residual cost, and the difference is recorded as a loss or gain on the sale.
Amortization vs Capitalization
The word capitalization has broad usage across accounting and finance. In fact, capitalization and amortisation have nearly identical definitions in some instances. In reference to assets, capitalization describes accounting for the cost of something over time rather than in the period that the expense is incurred.
For example, capitalization is the action of amortizing or depreciating an asset or expense over a period of time other than when the expense took place. The difference between amortisation and capitalization is that the former describes the reduction of value and method or schedule of that reduction while the latter simply describes the action of paying something in a period other than when the expense was incurred, and unlike amortisation, capitalization may refer to both tangible and intangible assets.
Capitalization can also refer to much more than the process of recording an expense in a different period. In finance, it is the sum of a company's long-term debt and its equity such as stock and retained earnings. It can also refer to the total value of a company. Market capitalization is the total value of a company's stock, calculated by multiplying the share price with the number of shares outstanding.
Its importance is derived from the fact that it can be helpful for measuring the financial health and size of a company. For example, the amount of liabilities of a company divided by its total capitalization shows what percentage of a company's value is debt. Market capitalization is also an important factor in valuing companies, as those with a small market cap may be able to have higher growth than companies with large market capitalization because the same amount of income would contribute to a relatively much larger size of growth to a company with a smaller market capitalization.
An example of this would be if two companies received investments of $1 million, but one had previously been worth $20 million and the other was only worth $2 million. The latter would have much greater growth than the former even though they both generated the same amount of revenue. The larger a company is, the harder it is to have extremely high growth because it requires so much capital.
Amortisation schedule: Formula and calculation
Amortisation schedules, also known as amortisation tables, are used to organize and keep track of debt repayment schedules. These schedules organize the information into a table to make it easier for people to plan their payments. It shows the number and amount of payments within the life of a loan or asset and shows how much is paid towards principal and interest. It often includes the date of payment, beginning of period balance (BOP balance), total payment, interest, principal, and end of period balance (EOP balance). Typically the last line of the schedule shows the sum of all the payments over the life of the loan or asset.
There are different methods of amortising an asset and organizing a schedule, and so some may appear slightly different from others. For example, in the effective interest rate method, there may be columns showing the discount or premium on the bond. Shown below is an example of a schedule that uses a method called the straight-line method, and that assumes a 6% interest rate. In a normal repayment schedule, the date of payment would appear rather than the number of payments.
It is important to make sure that your lender shows you a schedule of your loan before you take the loan. This way, you can see how much is owed in total and how much is owed in each expense, as well as how long you have before it must be paid off. It is important to understand that the tradeoff between different types of loans is usually how large the total interest expense is and how long the loan term is.
These schedules are helpful for accounting, budgeting, and tax reasons. Applications like Microsoft Excel are very useful for creating schedules if you'd like to accomplish mastery of excel you can check out our Excel Modeling Course. Below is a video from our Real Estate Modeling Course that gives you insight into creating your own schedule.
Treatment and effect of amortization on the 3 financial statements
Amortisation appears in both the income statement and the statement of cash flows. The income statement is a financial statement that shows the earnings and expenses of a company and calculates its net income. The statement of cash flows is similar, however, it is divided into operating activities, financial activities, and investment activities and shows the income and expenses from each segment. Amortisation and depreciation are typically found in a company's operating activities. It is considered a non-cash expense and for this reason, it is often added back while calculating cash flows from net income in the cash flow statement.
Hence, the effects of passing an entry to amortize an asset are:
- The value of the intangible assets and retained earnings in the statement of financial position (balance sheet) gets reduced by the amount of expense
- The expense portion of the income statement increases and by extension the net income of the company decreases
- The amount of expense is added back to net income while calculating cash flow in the cash flow statement to nullify the effect of the non-cash item.
It is also recorded in a company's general ledger, although this is not usually publicly available. It is considered a contra account, meaning that it decreases the value of the account is reduced. For example, when amortizing an intangible asset in the ledger, you would credit the account of the intangible by the amount expensed and debit an amortisation account by the same amount. This reflects the reduction in the value of the asset and the expense recorded. This is called double-entry accounting and is used to more effectively manage assets and liabilities and equity, and reduce mistakes. At any one time, a company's debits and credits should be equal.
Methods of amortization
There are many different types of amortization that companies use for different purposes. For example, many companies use methods that create a steady decrease in value for intangible assets such as patents because they are likely to be equally useful throughout their useful life. In other cases, it may be beneficial to consider other methods depending on the situation.
While this article describes these methods in terms of amortisation, it is important to recognize that many of these methods may be applied to depreciation as well. These concepts are used in different contexts, but they both apply to the reduction of value, meaning that both can be similarly calculated. In fact, it is extremely common to use these methods in order to calculate depreciation, in particular with the declining balance method, and the straight-line method.
Each method has different advantages and disadvantages. For example, while some may make payments more digestible and more evenly distributed across each installment, it may make interest rates higher than a loan that pays off more at the beginning of the loan's life, and conversely, it requires greater repayment of the principal upfront than a loan that doesn't require large installments until the end of the loan.
Bonds, for example, pay very little in installments throughout the loan's life and deliver a lump sum payment at maturity. This means that a company does not have to pay back the majority of the loan for a long period of time, but it also results in higher interest expenses overall, in essence, all loans are useful in different circumstances. While it may seem like one is better than the other, each method can be equally useful in specific situations and are worth understanding so that you can understand which method may be best for you.
The straight-line method also called the linear method or fixed principal method is considered one of the most simple methods of value reduction and is used very frequently for assets and debt. Despite what it might sound like, the straight-line method does not repay loans in equal installments. Rather, this method is called the straight-line method because it has a constant rate of principal repayment, meaning the principal portion of each installment is equal. This is calculated by dividing the total amount owed by the number of payments.
What makes installments unequal is the interest payments in each installment. Interest is calculated by charging interest only on the outstanding balance of the loan; while the interest rate remains constant, the interest charged decreases throughout the life of the loan as the balance is paid off.
In the case of the straight-line method, the amount of interest payment declines over the life of the loan and the amount of each principal payment is uniform, causing each installment to decrease over the loan's life. Examples of the straight-line method may appear in mortgage plans, bank loans, and intangible assets such as patents or franchisee licenses.
When applied to intangible assets, the straight-line method is very easy to calculate because there is no interest involved, meaning that the book value of the asset is reduced an equal amount every year until its useful life is over. Intangible assets use this method because they often hold the same amount of value every year. The straight-line method may be used for both assets and for debt because of its simplicity.
Below is an example of the straight-line method within a repayment schedule. This schedule assumes a 6% interest rate and does not include dates as a normal schedule would.
Declining balance method
The declining balance method is a method that involves paying greater installments at the beginning of the debt repayment and smaller installments closer to the loan's maturity date. This method is fairly similar to the straight-line method, except that instead of having a constant principal payment, the book value of the debt or asset is multiplied by an amortisation rate. This rate is simply a percentage that is multiplied by the loan's outstanding balance in order to calculate the amount of the principal in each installment. This means that the installments at the beginning of the loan's life are considerably larger than at the end.
The interest is calculated the same way as the straight-line method, with the interest rate multiplied by the outstanding balance. In this method, both the principal payments and interest payments decrease over the life of the loan as they are both calculated as a percentage of the outstanding balance.
One of the advantages of the declining balance method is that the interest expense is typically quite low because so much of the principal is paid off early on in the loan. While this method is great for low-interest rates, it comes at the cost of higher payments upfront, which may negate the entire reason for getting the loan in the first place.
When it comes to intangible assets, the declining balance is another commonly used method. This method is used when a company believes that an asset will be more useful at the beginning of its life than towards the end of its life, which is reflected in the large reductions in value early on and smaller reductions towards the end of its useful life.
Shown here is an example of the declining balance method. This repayment schedule assumes a 6% interest rate and a 40% amortisation rate. The last payment is larger because it pays off the remainder of the principal.
Balloon and bullet methods
The balloon method and bullet method have a considerable amount of overlap. Most notably, both balloon loans and bullet loans have relatively small installments and include a large lump sum payment at the loan's maturity.
There are also some key differences between these two methods. A balloon loan is different from a bullet loan due to the fact that it may include small repayments of the principal in installments, but typically the final payment is at least twice as large as any principal paid before maturity. In many cases, each installment made prior to maturity is equal, while the principal grows and the interest shrinks throughout the loan's life. Sometimes, a balloon loan only contains interest payments and pays the entire principal back upon maturity, but this is more characteristic of a bullet loan.
Shown below is an example of the balloon method with a $10,000 installment and 6% interest, and a lump sum payment at maturity.
In a bullet repayment, however, usually, only the interest is paid throughout the life of the loan, and the entire principal is paid back upon maturity. Sometimes even the interest is held until maturity, resulting in a very large lump sum payment of both the principal and accrued interest. Below is an example of the bullet method with a 6% interest rate.
When considering either a bullet repayment or balloon repayment it is important to look at the details to understand the exact repayment method. Banks seldom provide balloon or bullet-type loans for fear of never receiving the principal payment at the end of the loan. The balloon method is sometimes offered on mortgages for people with extremely good credit and a sizable amount of income. Most commonly, this kind of credit is reserved for reliable companies and for governments. This type of repayment structure is most commonly found in bonds.
The method of negative amortizing an asset is very different from other methods because rather than paying off debt, the outstanding debt increases over time. This occurs because the payments made do not meet the amount of interest owed on the debt, and the remaining interest is added to the loan's outstanding balance.
In some cases, this method is used in home mortgages. Most commonly, this method is found in the graduated-payment mortgage (GPM), which charges only part of the interest payment early in the repayment and charges more later on. It can also be used in the payment option adjustable-rate mortgages (ARMs), which permit debtors to choose the amount of interest paid in each installment.
This method is not usually recommended because a person is unable to repay their loans this way, and can become extremely risky if the outstanding balance of the loan becomes greater than the value of their purchase because selling the asset will not be enough to cover the costs of the debt. In some circumstances, however, this method can be useful.
This method may make sense if a person is unable to cover the full cost of installments at the beginning of the loan, but expects to have more money later. For example, if somebody loses their job and is unable to pay installments, it may make sense to consider this method until they are able to find another job or find another way to repay the remaining balance.
Below is an example of this method shown in a repayment schedule. This schedule does not show the loan being repaid because this method accumulates greater debt rather than paying it off. In this example, the total payment is only 5% of the principal, while interest is 6%, and the difference is added to the amount owed.
The fixed-rate method, also known as the mortgage style method, is a method of debt repayment where the installments are equal throughout the life of the loan, potentially excluding the final payment made which may be slightly larger or smaller in order to pay off the remaining loan's balance. This kind of installment is known as equated monthly installment (EMI), meaning that each installment is equal. This is accomplished by having each principal payment increase while each interest payment decreases.
The installments remain steady throughout the loan's life and interest is paid on the amount of outstanding debt. The principal payment increases in each successive payment in order to keep each installment equal. This method is less straightforward to calculate than some other methods, but it makes paying each installment very easy because they are equal. This method is very common in both home mortgages and auto loans because it provides the borrower with equal payments to make throughout the life of the loan.
This method is very common because it is straightforward for the borrower and is lucrative for the lender because the outstanding balance decreases more slowly, meaning that interest payments are larger for a longer period of time. Typically, the fixed-rate method includes monthly installment payments.
The equation to calculate the monthly installment is:
I = P*(i(1+i)^n/((1+i)-1))
This equation assumes a monthly installment where I = monthly installment, P = principal, i = interest, and n = total number of payments. Imagine an example where a person buys a house for exactly $100,000 with 0 down and gets a loan for 4 years. To better illustrate this method below is an example of a schedule that uses the fixed-rate method that assumes a 6% interest rate and assumes that the mortgage will be paid in 4 years (48 months).
Effective interest rate method
This method is used to pay off the premium or discount on a bond. The schedule of this method depends on whether there is a premium or discount on the bond.
If there is a discount the installment increases over the life of the bond. The installment is calculated by finding the effective (market) rate of interest on the discounted bond. The current market interest rate is used to discount the cash flows over the term of the bond and bring it to its current value. The interest expense is recorded at prevailing market rates and not the coupon rate that is paid out. If the coupon rate is greater than the market rate, the principal portion to be repaid decreases and vice versa. Schedules for both situations (market interest rate higher than coupon rate and vice versa) are illustrated below for better understanding.
An example of the effective interest rate method with a discount is found very commonly in bonds. This type of discount happens when a company offers a bond at an interest rate that is below-market interest rates, and they must sell the bond at less than face value, called a discount. Below shows a schedule for a $4,000 discount on a 5% bond with a market interest rate of 5.5%. The last payment is unusual because it pays off the remaining discount.
Just as a discount is applied to a bond sold with an interest rate below market value, bonds may be sold at a premium if they offer an interest rate above market value. Below is a schedule for a $4,000 premium on a 5.5% $100,000 bond with a market interest rate of 5%. The last payment is unusual because it pays off the remaining premium.
The effective interest rate method is used for presenting debt repayments in accounting statements.
In some instances, people may be eligible for reamortisation. This method allows a person to pay off a large portion of the remaining principal in a single payment, which can reduce future payments by lowering interest expenses and the principal paid back in each installment. This occurs because interest is only paid on the remaining balance, so reducing a large part of the outstanding balance can substantially reduce interest payments, and less principal is needed to pay back the remainder of the loan. This typically has no effect on the loan term, while the installment decreases the remaining time frame of your loan will be the same. It can be a great method of reducing a person's debt load, and can typically be easier than refinancing a loan.
Unfortunately, not every loan is eligible for reamortisation, some lenders do not offer this service and some lenders exclude certain types of loans from eligibility. Loans backed by the Federal Housing Administration as well as loans made by the Department of Veteran Affairs are ineligible. In addition, some other lenders do not allow this and it's best to ask your particular lender if your loan is eligible. In many cases, in order to be eligible for this, a lender will require that the lump sum payment meets a minimum amount of the principal.
Consider an example where a $100,000 loan is being paid off over the course of 10 payment periods, but the debtor inherits a large sum of money that they decide to use to pay off a portion of the loan's outstanding balance and reduce the size of the remaining installments. To better illustrate this scenario below is a schedule with an extra $5,000 principal included in the 5th payment and a 6% interest rate.
Line of credit method
The line of credit method allows people to borrow multiple times in a given period and then pay back at a specified date. In this method, there is a draw period in which people may borrow money against their credit and then a repayment period in which people repay the principal and any interest.
As the name would suggest, this method is how a person's credit card operates. This method is extremely common as most people have a credit card. With a credit card, there is a draw period, and a period at which the payment is due, however, a person may pay back their balance at any time. It is important to note that credit cards often have a limit on how much someone is able to spend in a draw period. Most credit cards only charge interest if you do not pay your balance each month, and if you don't pay your minimum balance they may further penalize you with charges. The interest rate a credit card company charges are known as the annual percentage rate (APR). The interest rate you pay on a credit card can be influenced by your credit score and which card you choose to use. In many cases, credit card companies do not charge interest for a specified amount of time after you first get your credit card.
For example, consider the common case of making multiple expenses on a credit card over the course of a month, and paying the balance off before the end of the month. More than likely, you will not need to pay any interest on the loan and will only pay the principal in full at the payment period. Below is an example of how the line of credit method may look in a table. There is a period of purchases where debt accrues and then a repayment period where the principal is repaid.