AMORTIZATION

Amortization, an accounting concept similar to depreciation, is the gradual reduction of an asset or liability by some periodic amount. In the case of an asset, it involves expensing the item over the time period it is thought to be consumed. For a liability, the amortization takes place over the time period the item is repaid or earned. It is essentially a means to allocate categories of assets and liabilities to their pertinent time period.

The key difference between depreciation and amortization is the nature of the items to which they apply. The former is generally used in the context of tangible assets, such as buildings, machinery, and equipment. The latter is more commonly associated with intangible assets, such as copyrights, goodwill, patents, and capitalized costs (e.g., product development costs). On the liability side, amortization is commonly applied to deferred revenue items such as premium income or subscription revenue, where the cash payment is often received in advance of the earning process, and therefore must be recognized as income ratably over some future time.

Amortization is a means by which accountants apply the period concept in accrual-based financial statements: income and expenses are recorded in the periods affected, rather than when the cash actually changes hands. The importance of spreading transactions across several periods becomes more clear when considering long-lived assets of substantial cost. Just as it would be inappropriate to expense the cost of a new facility in the year of its acquisition, it would be wrong to fully expense an intangible asset in the first year. Intangible assets generally benefit many future periods, and accordingly their expense should be spread over the time period the company will use the asset or generate revenue therefrom.

The periods over which intangible assets are amortized vary widely, from a few years to 40 years. Leasehold interests with remaining lives of three years, for example, would be amortized over the following three years. The costs incurred with establishing and protecting patent rights would generally be amortized over 17 years. The goodwill recorded in connection with an acquisition of a subsidiary could be amortized over as long as 40 years past the author's death, and should also be limited to 40 years under accounting rules. The general rule is that the asset should be amortized over its useful life.

It is important to realize that not all assets are consumed by their use or by the passage of time. A good example of a tangible asset that is not depreciated is land; its value generally is not degraded by time or use. Within the intangible arena, trademarks can have indefinite lives, and therefore are often not amortized. The cost of acquiring customer lists, if properly maintained, can also be argued to not decline in value.

The term amortization is also used in connection with loans. The amortization of a loan is the rate at which the principal balance will be paid down over time, given the term and interest rate of the note. Shorter note periods will have higher amounts amortized with each payment or period.

The loans most people are familiar with are car or mortgage loans, where 5and 30-year terms, respectively, are fairly standard. In the case of a 30-year fixed-rate mortgage, the loan will amortize at an increasing rate over the 360 months' payments. Although the monthly payments will remain constant, the amount allocated to interest and principal will shift as time passes, with increasing amounts applied toward principal repayment and decreasing amounts applied to interest. For example, a 30-year mortgage of $100,000 at 8 percent will have equal monthly payments of $734. The first month's payment will consist of $667 interest and $67 of principal amortization, whereas the last payment will include very little interest and substantially all principal.

Another type of amortization involves the discount or premium frequently arising with the issuance of bonds. In the case of a discount, the bond issuer will record the original bond discount as an asset (a deferred cost) and amortize it ratably over the bond's term. The expense created by this amortization will effectively increase the interest expense above that from the pure coupon rate of interest, reflecting the fact that the issuer was forced to pay a higher interest rate (that is, accept less cash from the bond buyer than originally contemplated by the bond deal).