When a company owns an asset that loses value over time, it can calculate its losses and include them on a balance sheet as expenses. Three types of assets lose value over time: property, which includes everything from buildings to machinery and technology; natural resources such as oil wells; and intangible assets. "Amortization" means the loss in value of intangible assets over time. Various ways of calculating amortization exist, including the straight-line method.
Anything without physical substance that generates capital for a business or organization is an intangible asset. Intangible assets include things such as copyrights, patents, trade names, franchise rights, government licenses and goodwill. These things lose value as they expire or otherwise fail to produce dependable revenue streams. Accountants calculate amortization as a means of spreading the cost of an intangible asset across all the years of its profitable life span and determining the value lost.
The straight-line method of calculating amortization in the investment industry applies to bonds. A bond is a piece of a loan. A company sells bonds to raise large sums of money from individual small investors. For instance, if a company needs $100,000 in loans, it might issue one hundred $1,000 bonds.
All bonds possess maturity periods. When a bond reaches maturity, its book value must equal its original value, meaning the company must pay off all positive or negative interest on a bond. The money paid out to ensure that a bond equals its book value upon reaching maturity constitutes amortized funds.
Straight-Line Amortization Formula
The straight-line method of amortization applied to bonds requires little more than basic math. The formula reads Amortization/Interest Payments = (Bond Amount with Interest - Original Bond Amount) / Number of Periods.
Assume a $1,000 bond carries an actual value of $1,475 and a maturity period of five years, and an accountant calculates amortization payments annually. Amortization/Interest Payments = (1,475 – 1,000) / 5; or, 475/5 = 95. This company must pay $95 in amortization annually on the bond.
In some instances, bonds lose value and a company must pay the bond back up to its initial price. For instance, a bond issued at $1,000 might carry an actual value of $935. In such cases, amortization payments insure that the bond realizes its initial worth upon maturity.
The straight-line method of amortization gains its name from the uniform payments it creates. Using this formula allows accountants to develop a “straight line” of identical payments due at equally measured intervals over a predetermined period of time.
Though straight-line amortization applies to bonds in the investment industry, the method can technically apply to any situation in which a person or a company must make uniform payments over a set period of time. In real estate, for instance, mortgage payments are amortization. You can calculate payment amounts using the straight-line amortization method if you know the total value of the loan including interest and its length. Mortgage repayment constitutes amortization because the bank loses its claim to the loan, and thus loses an intangible financial asset.
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