Amortization

In economics, amortization is called the depreciation or decrease in value of an asset or liability.

In business terms, this term can have different meanings depending on what object it is attached to or in what modality. In all cases, the value of an asset or liability is related to its time or useful life, since as we can guess, all assets lose value over time, therefore, it is one of the ways to quantify loss of value.

Elements of a depreciation

We can distinguish between three the following basic elements:

• Useful life: It is the number of years to be considered.
• Residual value: It is the value of the good at the end of its useful life.
• Amortization base: Difference between acquisition value and residual value
• Kind: It will be the criterion used when establishing it (fee, wear ...).

In this sense, for an asset the amortization (accounting) will be the decrease or loss of value over time, while for a liability it refers to the decrease in credit, debt.

In liabilities, amortization (financial) refers to the ability to repay a loan, relative to its principal, not including interest. In a practical example, let's imagine an initial loan of 1,000 euros, with 5% interest payable monthly and in year 5 and month 6 we have paid 150 euros of capital and 180 of interest. The amortization in this case would be 150 euros, and the outstanding capital of 850 euros.

Practical example for an asset

Let's imagine a new car for 20,000 euros with a depreciation of 20% per year, that is, 4,000 euros per year. Therefore, the useful life is 5 years (1 / 0.2) and its base will be, for example, in year 3 of 12,000 euros. Why? Because we will subtract 4,000 euros from the initial value (20,000 euros) each year.

The amortization can be constant, or with another criterion, for example, the number of kilometers that the vehicle makes or wear and tear. Accumulated amortization refers to the amount of resources that we have amortized from origin.

Read difference between accounting and financial amortization.