Amortization

Defintion

Amortization refers to the process of gradually reducing or paying off a debt, such as a loan or a mortgage, over a specific period of time through regular payments.

What is amortization?

These payments typically consist of both the principal amount borrowed and the interest that accrues on the outstanding balance.

Amortization schedules outline the payment plan, detailing how much of each instalment goes towards reducing the principal balance and how much covers the interest. In the initial stages of a loan, a larger portion of the payment goes towards interest, while over time, the proportion allocated to the principal increases. This systematic approach ensures that the debt is fully repaid by the end of the agreed-upon term.

Amortization is commonly used in various financial contexts, including home mortgages, car loans, and other types of instalment loans. It helps borrowers manage their repayment obligations and allows lenders to receive a consistent stream of payments over the life of the loan. Try our amortization calculator today.

Example of amortization

1. Intangible asset acquisition:
   • On January 1st, Tech Innovators acquires a patent for a new technology by paying $120,000. The patent has a useful life of 4 years.

   The accounting entry for the acquisition is:

   $\text{Patent}(Intangible\; asset)=\; \$120,000$

   This entry records the initial cost of the patent on Tech Innovators’ balance sheet.

2. Amortization process:
   • Since the patent has a useful life of 4 years, the annual amortization expense is calculated as $120,000/4 = $30,000

   The monthly amortization expense is $30,000 / 12 = $2,500

3. Monthly amortization entry:
   • At the end of each month, Tech Innovators records the amortization expense to reflect the portion of the patent’s cost that has been expensed.

   The accounting entry for monthly amortization is:

   $\text{Amortization expense}(Expense)=\; \$2,500$

   $\text{Accumulated amortization}=\; \$2,500$

   The accumulated amortization account is a contra-asset account that accumulates the total amortization expense over the patent’s useful life. It reduces the carrying value of the patent on the balance sheet.