What is an Amortization Schedule and How to Calculate it

Introduction

Understanding the intricacies of financial concepts can often feel overwhelming, especially when it comes to managing loans and repayments. One important concept is the amortization schedule, a powerful tool that helps businesses determine their loan obligation over time. 

An amortization schedule details each payment period, including the exact amount that goes to interest and the principal. This provides clarity to businesses in terms of how their money is applied to loan balance and interest,facilitating better financial planning and gauging the long-term borrowing cost.

Understanding how amortization is essential in managing loans and intangible assets. In this blog, we are going to understand what an amortization schedule is, types of amortization and a step-by-step method for calculating amortization for loans and intangible assets. 

What is Amortization?

In accounting, amortization refers to the process of recording equal loan installments. Recording these payments periodically reduces the book value of a loan or an intangible asset over the specified duration. Calculating amortization helps determine how to repay your debt over a given time period.

Amortization, in other words, is the practice of spreading the cost of intangible assets or a loan over a fixed time period. This systematic reduction in the value of an asset over time helps recognize the expense in a structured manner. For loans, it involves paying off the principal and interest through regular installments, while for intangible assets, it entails gradually expensing the asset’s cost over its useful life.

Types of Amortization

There are typically two types of amortization: loan amortization and intangible asset amortization. Understanding their differences is critical for effective management of financial obligations and assets. Though they share some commonalities, each has its own unique characteristics and methodologies. In this section, we will explore these differences in detail.

1. Loan amortization

   Loan amortization is the process of repaying a loan in installments over a specified period of time. Each installment comprises both principal and interest components. Over time, the interest decreases while the principal increases. This way, the loan will be fully settled at the end of the periods of repayment. 

   Let us look at some of its components below:

   • Periodic payments:Loan amortization involves breaking down the repayment of a loan into regular installments, typically monthly.
   • Interest and principal: Each payment is divided into an interest portion and a principal portion, with the interest portion decreasing over time and the principal portion increasing.
   • Loan term: The structure ensures that the loan is fully repaid by the end of the term. 
   • Amortization schedule: An amortization schedule outlines each payment, detailing how much goes towards interest and the principal amount.

2. Intangible asset amortization 

   Intangible assets, such as patents, trademarks, and goodwill, also require amortization. It is an accounting procedure which calculates the cost of an asset over its useful life. The amortization of the intangible asset, acts as a non-cash accounting entry as it is not involved with any cash payment. 

   Let us look at some of its components below:

   • Non-cash expense: Intangible asset amortization is a non-cash accounting entry, reflecting the gradual consumption of an asset’s value over its useful life.
   • Straight-line method:The most common method used is the straight-line method, which spreads the asset’s cost evenly across its useful life.
   • Useful life estimation: To determine the annual amortization expense,the useful life of an intangible asset, such as a patent or trademark, is estimated. 
   • Book value adjustment: Each year, the asset’s book value is adjusted to reflect the amortization expense, ensuring accurate financial reporting.

How to Calculate Loan Amortization 

Calculation of loan amortization requires the calculation of a periodic payment amount and breaking down that payment amount into interest and principal. Here’s the step-by-step process to calculate loan amortization::

• Determine the loan details: Identify the loan principal (P), annual interest rate (r), and the loan term (n) in months.
• Convert the annual interest rate to a monthly rate: Divide the annual interest rate by 12 to get the monthly interest rate.
• Use the amortization formula: 

Apply the formula to calculate the monthly payment (A)

where,

A is the monthly payment
P is the loan principal
r is the monthly interest rate
n is the number of payments 

• Break down the payment: For each payment period, calculate the interest portion (which is the remaining balance multiplied by the monthly interest rate) and subtract it from the total payment to get the principal portion.
• Update the balance:Subtract the principal portion from the remaining loan balance.
• Repeat for each payment:Continue the process for each payment period until the loan is fully paid off.

Example of Amortization of a Loan

Here’s an example of calculating the amortization of a loan:

Alex takes out a mortgage loan for $200,000 with a payment period of 15 years and an annual interest rate of 4.5%. He creates an amortization chart to monitor the amortization of his loan. He starts by determining how many months the amortization of his loan will take:

Alex adds 180 rows to his chart. His loan is for $200,000, and this number is his principal for the first month because this is the total amount he has to pay back. His annual interest rate is 4.5%, which he converts to a monthly interest rate:

He then calculates the monthly payment using the amortization formula:

A = 1529.99

Each monthly payment is approximately $1529.99. Now, he calculates the interest and principal portions for the first month.

First Month:

• Interest: 200,000 × 0.00375 = 750200,000
• Principal payment: 1529.99 − 750 = 779.99
• Remaining balance:
  200,000 − 779.99 = 199,220.01

He fills in the first month of his chart:

Alex will repeat this process for each month, updating the interest, principal payment, and remaining balance until the loan is fully paid off.

How to Calculate Amortization for an Intangible Asset

Calculating amortization for intangible assets involves estimating their useful life and systematically expensing the asset’s cost. Here’s how to do it:

• Determine the initial cost and useful life: Identify the initial cost of the intangible asset and estimate its useful life.
• Subtract the residual value: If there is any residual value, subtract it from the initial cost. Often, intangible assets have no residual value.
• Calculate the annual amortization expense:
  Use the formula:
  Annual Amortization Expense = (Initial Cost − Residual Value) / Useful Life
• Record the expense: Each year, record the amortization expense in the financial statements.

Example of Amortization of an Intangible Asset 

Here’s an example of calculating the amortization of an intangible asset:

XYZ Corporation acquires a trademark for $60,000 with a useful life of 10 years and no residual value. They need to calculate the annual amortization expense to reflect the asset’s decreasing value accurately.

• Initial cost: $60,000
• Useful life: 10 years
• Annual amortization expense= (Initial Cost − Residual Value) / Useful Life

Annual amortization expense = 60,000 − 0 / 10 = 6

Each year, XYZ Corporation will record a $6,000 amortization expense until the trademark is fully amortized. They prepare an amortization schedule as follows:

By following this schedule, XYZ Corporation ensures accurate financial reporting and compliance with accounting standards.

How to Prepare an Amortization Schedule

An amortization schedule is an itemized table showing each periodic payment for a loan or the annual expense of amortization for an intangible asset. In case of loan, it details the payment number, amount, interest portion, principal portion, and remaining balance. For intangible assets, it includes the year, beginning book value, amortization expense and ending book value.

Steps to prepare a loan amortization schedule

1. Calculate the monthly payment:
   • Gather all the loan information, i.e., principal, interest, and term. 
   •  Derive the monthly payment using the amortization formula.
2. Calculate the principal and interest component of each payment:
   • Calculate the interest component of each payment by using the formula: 

   Interest Component = Outstanding Loan Balance × Monthly Interest Rate

   • Subtract the interest portion from the total monthly payment to get the principal portion.
3. Subtract the principal portion from the remaining balance:
   • Deduct the principal portion from the remaining loan balance to get the updated loan balance.
4. Do the same for all payment periods:
   • Repeat the above steps for every payment period until the loan is paid entirely. 
   • Update the balance and record the breakdown of every payment.

Steps to make an amortization schedule for an intangible asset

1. Calculate the annual amortization expense:
   • Calculate the annual amortization expense using the initial cost, residual value (if any), and the useful life of the asset.
2. Subtract expenses from book value every year:
   • Each year, subtract the amortization expense from the book value of the asset to reflect its decreasing value.
3. Repeat until the asset is completely amortized:
   • Continue the process each year until the asset’s book value is fully amortized, ensuring accurate representation in the financial statements.

How HighRadius Can Help?

HighRadius offers a cloud-based Record to Report Suite that helps accounting professionals streamline and automate the financial close process for businesses. We have helped accounting teams from around the globe with month-end closing, reconciliations, journal entry management, intercompany accounting, and financial reporting.

Our Financial Close Module is designed to create detailed month-end close plans with specific close tasks that can be assigned to various accounting professionals, reducing the month-end close time by 30%. The workspace is connected and allows users to assign and track tasks for each close task category for input, review, and approval with the stakeholders. It allows users to extract and ingest data automatically, and use formulas on the data to process and transform it. 

Our Account Reconciliation Module provides an out-of-the-box formula set that can configure matching rules and match line-level transactions from multiple data sources and create templates to automate various transaction processing required for month-end close. Our solution has the ability to record transactions, which will be automatically posted into the ERP, automating 70% of your account reconciliation process. 

Our AI-powered Anomaly Management Module helps accounting professionals identify and rectify potential ‘Errors and Omissions’ on a daily basis so that precious resources are not wasted during month close. It automates the feedback loop for improved anomaly detection and reduction of false positives over time. We empower accounting teams to work more efficiently, accurately, and collaboratively, enabling them to add greater value to their organizations’ accounting processes.

FAQs

1) Does depreciation and amortization always increase?

No, they do not always increase. They are the methods to allocate the cost of tangible and intangible assets respectively over time. The expense is consistent or may even decrease, depending on the method used. They lower the book value of that asset every year until it is fully expensed.

2) What is an amortization table?

An amortization table is a timetable attached to each periodic loan payment. This table shows how each of the payments is allocated between interest and principal, as well as the remaining balance. It helps borrowers understand how each of the payments will be applied to the loan during its lifetime.

3) How to calculate amortization expenses?

 Using the straight-line method, calculate annual amortization expense by subtracting residual value from cost and dividing by useful life. For example, for an asset that costs $50,000, has a 10-year useful life, but has no residual value: annual amortization expense would be $5,000.

4) Is amortization an operating expense?

Yes, amortization is an operating expense. It appears on the income statement as a non-cash expense. It reflects the allocation of an intangible asset’s value over its useful life, impacting operating income. Therefore, with its nature, amortization is considered to be an operating expense.

5) What is the difference between depreciation and amortization?

Both depreciation and amortization match the costs of assets over their life. The key difference is the asset type: depreciation is applied to tangible assets, say, machinery, while amortization is applied to intangible assets like patents. In either case, expenses are distributed to reflect use and value deterioration.