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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