Amortization is the paying off of debt with a fixed repayment schedule in regular installments over a period of time for example 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 is similar to depreciation, which is used for tangible assets, and to depletion, which is used for natural resources. When businesses amortize expenses, it helps tie the cost of the asset with the revenues it generates. For example, 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. Conversely, with a large asset, the business reaps the rewards of the expense for years, so it writes off the expense incrementally over several years.
On auto loan and home loan payments, at the beginning of the loan term, most of the monthly payment goes toward interest. 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, the first payment of $386.66 allocates $286.66 to principal and $100 to interest. The last monthly payment allocates $384.73 to principal and $1.92 to interest. Similarly, mortgages can be amortized. See Investopedia's mortgage calculator below for an example.
To illustrate the amortization of an intangible asset, imagine XYZ Biotech spends $30 million dollars on a patent with a useful life of 15 years. Theoretically, to account for the expense over a 15-year period, XYZ Biotech records $2 million each year as an amortization expense.
Amortizing capital expenses helps present a more accurate view of the company's financial health. To continue with the above example, if XYZ Biotech writes off the entire cost of the expense in the year of purchase, the large amount detracts from the company's revenue for that year, making it look as though the company earned less. In contrast, by spreading the expense out of several years, the ledger reflects the true cost of doing business. Also, spreading the expense over several years can help to make tax liability more consistent.
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. Amortization can be calculated easily 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 4563. The IRS has schedules dictating which percentage of an asset's cost a business should amortize each year, and these schedules break intangible assets into categories with slightly different amortization rates.