What is Amortization?
Amortization refers to the practice of spreading the cost of an intangible asset over its useful life. The key word here is “intangible.” As we’ll see later this is a key differentiator when comparing the term to depreciation.
When a company engages in an intangible expense like a licensing Amortization and depreciation have long been mainstays of corporate income statements. However, many people fail to recognize that these terms are just as important to the financial well-being of the individual. In this article we’ll look at what the terms mean, how they differ, and why they’re important if you want to get a handle on your finances.
agreement, they may be required to pay the full price in one sum. However, the utility of the licensing agreement is realized over the following 10 years.
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During this decade the company is benefiting from the value of the asset. Therefore, it’s appropriate for this one-time expense to be recorded as if it is incurred in a series of smaller,
equal payments on an income statement. Spreading out the cost with this account method serves the purpose of incurring the burden of the cost equally among several years rather than all at once, which may make profitability in ‘year one’ impossible.
What is Depreciation?
Depreciation works in a similar fashion to amortization. However, the difference here is that it refers to a tangible asset. In many cases a tangible asset will be a piece of industrial equipment, a vehicle or even the physical components of an IT infrastructure. The single, one-time cost of the equipment is recorded over the span of time which represents the expected life of the asset.
For example, a printing press costing $100,000 may have an expected useful life of 10 years. This means that, from an accounting perspective, the company will absorb $10,000 worth of the cost each year for 10 years. This even spread is referred to as “straight line” depreciation because it assumes the equipment will have a consistent level of usefulness each year.
In reality, a machine is likely to be used less at the end of its life compared to the beginning. Some accountants choose to reflect this by engaging in “accelerated depreciation”. Under this method the costs incurred in the early years is far greater than the costs recorded in the final years.
What are the differences?
Again, the most critical difference relates to the type of asset in question. If we’re talking about an intangible asset (e.g. patent, trademark, service contracts, order backlogs, etc.) then the term amortization is the most appropriate. A physical asset (e.g. forklift, warehouse shelving, building, etc.) falls under the term depreciation.
These two terms share the characteristic of being “non-cash” expenses. That is, they don’t impact the cash flow of the company because the annual expense incurred is reflected on the income statement but doesn’t actually reflect dollars withdrawn from an account. Remember, in the case of both amortization and depreciation the true payment is made in one installment.
Why should you care?
Amortization is important not only for a company but for the individual as well. When we purchase a home with a conventional mortgage, we are basing payments on an amortization schedule.
Example of an amortization schedule
This important document shows the breakdown of payments owed over the full life of the mortgage. An amortization schedule is the clearest, physical representation of the total cost of a home. This matters because the document provides a detailed analysis of the total interest paid for the financing of the property.
Depreciation is also important to the individual homeowner as it reflects how the value of their home may decrease over time. This was particularly the case during the housing market bubble in recent years.
The Cobalt Corporation decides to invest in a specialized centrifuge to accelerate the processes of their chemical plant. This expensive machine will cost $300,000. Field experts believe the centrifuge will remain a useful component of the laboratory for the next 15 years. In the interest of simplicity they decide to use the common method of straight-line depreciation. Therefore the annual “cost” incurred on the income statement for each of the following 15 years will be $20,000 ($300,000/15 Years).
How to calculate amortization
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It’s important for prospective homeowners to understand that a home, like any investment, can lose value over time as a result of local and national economic factors. In dramatic cases the
home can go “under water” meaning that the balance of the mortgage is actually greater than the value of the home in today’s market.
How to calculate depreciation
In order to understand how depreciation is calculated, let’s illustrate it with an example…
Alexis graduates from college and buys a new car for her commute to a new job. The cost of the vehicle is $35,000. She finances the purchase with a five-year auto loan at a 5% interest rate. Her first payment of $660 breaks down to $146 in interest and $515 in principle per the amortization table. However, her last payment of $660 breaks down to just $3 of interest and $658 in principle. She is paying off debt with regular, fixed payments. However, the portion of the payment applied to interest diminishes over the life of the loan.