What is Amortization?
Amortization is an accounting technique used to lower the cost value of a finite life or intangible asset incrementally through scheduled charges to income. Amortization is the paying off of debt with a fixed repayment schedule in regular installments over time like with a mortgage or a car loan. It also refers to the spreading out of capital expenses for intangible assets over a specific duration – usually over the asset's useful life – for accounting and tax purposes. Amortization can refer to paying off debt over time in regular installments of interest and principal sufficient to repay the loan in full by maturity. Amortization can also mean the deduction of capital expenses over the asset's useful life. In this case, amortization measures the consumption of the value of an intangible asset, such as goodwill, a patent or a copyright.
Breaking Down Amortization
Amortization is like depreciation, which is used for tangible assets, and depletion, which is used for natural resources. When businesses amortize expenses, they help tie an asset's costs to the revenues it generates. For example, with a large asset, the business reaps the rewards of the expense for years. Thus, it writes off the expense incrementally over the useful life of that asset, tangible or intangible. By contrast, if a company buys a ream of paper, it writes off the cost in the year of purchase and generally uses all the paper the same year.
Amortization of Loans
With mortgage and auto loan payments, most of the monthly payment goes toward interest early in the loan. With each subsequent payment, a greater percentage of the payment goes toward the loan's principal. For example, on a five-year, $20,000 auto loan at 6% interest, $286.66 of the first $386.66 monthly payment goes to interest while $100 goes to principal. In the last monthly payment, $384.73 goes to principal and $1.92 goes to interest. Mortgage amortization works a similar way.
Amortization and the Internal Revenue Service
The Internal Revenue Service (IRS) allows taxpayers to take a deduction for certain amortized expenses: geological and geophysical expenses incurred in oil and natural gas exploration, atmospheric pollution control facilities, bond premiums, research and development, lease acquisition, forestation and reforestation, and certain intangibles such as goodwill, patents, copyrights and trademarks. One can calculate amortization using most modern financial calculators, spreadsheet software packages such as Microsoft Excel, or amortization charts and tables.
To deduct amortization costs, the IRS requires tax filers to complete Part VI of Form 4562. The IRS has schedules dictating which percentage of an asset's cost a business should amortize each year. These schedules break intangible assets into categories with slightly different amortization rates.