Amortization

Amortization has two closely related meanings in finance and accounting, and both involve spreading an amount evenly over time. In accounting, amortization allocates the cost of an intangible asset — a patent, license, or capitalized development cost — across its useful life, just as depreciation does for tangible assets like machinery. In lending, amortization is the scheduled paydown of a loan's principal through regular payments.

On the accounting side, a company that pays for a 10-year patent license amortizes the cost by expensing one-tenth of it each year, matching the expense to the periods that benefit from the asset. Amortization is a non-cash expense, which is why it is added back to net income when preparing the operating section of the statement of cash flows. Lease accounting uses the same mechanics: a lessee amortizes its right-of-use asset over the lease term.

In fixed income, amortization also describes adjusting a bond's cost basis. An investor who buys a bond at a premium amortizes that premium down toward par over the bond's remaining life, reducing reported interest income each year. Amortization is mandatory for tax-exempt municipal bonds and an election under IRC Section 171 for taxable bonds. Mortgage-backed securities and CMOs are amortizing securities — each monthly payment returns both interest and a slice of principal, unlike a conventional bond that repays principal only at maturity.

Amortization appears across many exams: the Series 7 tests premium amortization and amortizing securities like CMOs, the CMA tests lease and intangible-asset amortization, and the ACCA Financial Accounting exam tests amortisation of intangibles and its treatment in the cash flow statement.