In economics there are two meanings of the word amortization, as used from an economic-accounting point of view or from a financial point of view. In other words, one serves to amortize assets and another to amortize liabilities.
The economic-accounting amortization serves to amortize assets. Meanwhile, financial amortization is used to amortize liabilities.
In the following, each of the two concepts will be explained. Explaining in detail each of them.
Difference between accounting and financial amortization
Next we will see the difference between financial and accounting amortization:
- Accounting or economic amortization:When a company buys an asset, it uses it for a specific useful life. For example a van that lasts ten years. That is why he tries to distribute the cost of that van in the ten years.
We can understand accounting amortization as the reserve of money that is accumulating year by year in order to recover the initial investment before it can no longer be used to reach the end of its useful life. With this reservation, the company will be able to face the investment that will be to get rid of the current machine and acquire a new one that replaces it, once the current machine is no longer useful or working.
- Financial amortization:Refers to the part of the installment to be paid for a loan that corresponds to the principal (the amount of money requested). When paying a fee for a loan, one part is repayment (principal payment) and another is a financial expense (interest payment).
Fee = Principal + Interest
Imagine that you have applied for a loan to the bank worth € 10,000 (principal), and in the current month you have to pay a fee to the bank of € 1,000, of which € 800 corresponds to the payment of the principal (principal repayment) and 200 € to interest payment. This means that the value of the principal that you still owe to the bank will become € 9,200 (10,000 – 800), and the other € 200 of the payment of the fee would be the financial expense. In conclusion you would have amortized € 800.
Example of accounting and financial amortization
At this point we will present two examples to see the practical difference between accounting and financial amortization:
- Accounting or economic amortization
Suppose we have a company that manufactures plastic bottles. We have just bought a machine to manufacture them, whose useful life is estimated at 5 years. The value of the machine is $ 10,000. Therefore, if we apply the linear accounting amortization each year, the machine will have $ 2,000 less value. After 5 years it will stop working and we will have to buy another one. Therefore, each year we will amortize $ 2,000.
- Financial amortization
Now suppose that to acquire a certain ship to manufacture the bottles, we ask for a loan. The value of the loan is $ 50,000. Financial amortization refers to the payment of the debt we are making. When we pay off the debt, what we are saying is that we are “paying.” Amortization always refers to the principal and does not take interest into account.