The two distinctly different definitions of “amortization” explained.
The term amortization has two distinctly different meanings. And both definitions are used in the financial world, adding to the confusion.
Most folks will think of amortization as a loan repayment table for a car or home loan, and that is the most frequent usage of the term.
If you’ve bought a car or home with an installment or mortgage loan, you’ve most likely got somewhere in your files an amortization schedule which breaks down each monthly payments between interest expense and the amount applied to the loan principal. The amounts allocated to interest and loan principal vary each month as the principal balance due on the loan declines.
The other usage of the term amortization has no relation to the above.
Before moving into a discussion of the other meaning of the word amortization, let’s back up a moment and talk about the term depreciation. Depreciation is the yearly write-down on financial statements of tangible business assets, usually buildings, furniture, fixtures and equipment. This write-down of tangible assets is allowed by the IRS as an expense deduction on the profit and loss statement.
Now, let’s move back to the term amortization. Amortization in this second meaning is a first cousin to depreciation. It’s the write-down of intangible assets as opposed to the depreciation of tangible assets. Intangible assets can be the value of a patent, a trademark, a copyright or business goodwill. Intangible business assets are sometimes referred to as intellectual property.
If you see amortization listed on a profit and loss statement or tax return as an expense line item, you know that it’s this second meaning and therefore a write-down of intangible assets. If you see a chart or table filled with columns and rows of numbers, it’s an amortization table breaking down a loan repayment schedule into the amounts allocated monthly to principal and interest.
It’s confusing to have such distinctly different meanings attributed to the same word, with both being used in the financial world. We hope this article helps a bit to clear up the misunderstanding we frequently encounter in our mergers and acquisitions practice.
For further reading, here are additional articles that may be of interest:
- How to Use Valuation Guidelines to Estimate the Value of a Business
- How to Analyze a Business You’re Considering Buying
- How to Make a Written Offer to Buy a Business
- Seven Negotiating Rules When Buying or Selling a Business
- How to Conduct the Due Diligence When Buying a Business
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In a very fundamental way, the two definitions of amortization are the same – for intangible assets and a loan payments/receipts: “they represent the transfer of a portion of something of value over a set period of time – for income tax purposes.”
The (i) owner of intangible assets is able to write off a portion of his cost to acquire those assets – to reduce his income tax liability, over a set time period determined by the IRS – usually 15 years; and the (ii-a) owner of a loan is only obligated to recognize income from the interest portion of his loan payment receipts over the life of the loan, and the (ii-b) debtor can only write off the interest portion of his loan payments over the life of the loan – both for income tax purposes, and to comply with generally accepted accounting principles.
BTW: It’s important for business owners to understand the implications of amortization on the sale of their business, because the amortization of goodwill can be one of the biggest obstacles to closing the sale. Goodwill is the just the difference between the purchase price of the business and the final book value of the net tangible assets. It is not an income producing asset with intrinsic value.
Buyers want depreciated assets to be valued closer to original cost than sellers, because buyers are then able to shelter a greater amount of their income through the rapid depreciation of intangible assets, rather than the long/slow amortization of intangible assets. But sellers want the value of their tangible assets to be as low as possible, so they don’t have to pay additional taxes due to the “recapture of depreciation” taken in prior years.
Tom, great points. Thanks for stopping by.