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Information > Financial Terms > This page Amortization 1.
Literally, "killing off" or wiping out, a term applied to (1) the
gradual reduction of a debt by equal periodic payments sufficient
to pay current interest and to extinguish the principal completely by
final maturity (see AMORTIZED LOANS); (2) the periodic writing
off of an asset over a specific term, such as capitalized expenses (deferred
charges) and intangibles (such as goodwill, patents, trademarks, and copyrights). Depreciation is a process of regular amortization of the depreciable
cost, including accelerated amortization of defense-essential facilities. 2.
The process of periodically reducing or writing off the premium
on a bond brought above par, in order to bring its investment or basis
value into coincidence with par (face amount of denomination of the bond)
on the maturity date. The
premium paid for a bond at the time of purchase represents a part of the
investment which will not be returned at maturity.
Consequently, a part of the cash interest paid periodically on
the bond should not be regarded as income but as an amount to be applied
to the reduction of the premium.
This is accomplished by a charge at each bond interest date to
the cash interest account and a corresponding credit to the cost basis
on the bond or to valuation reserve, amortization of premium. To
illustrate the mathematical history of a bond bought at a premium and
carried currently on an investment basis, suppose a 6.0% tax-exempt bond,
paying interest semiannually March 1 and September 1, with a four-year
maturity, is bought March 1, 1978, to yield 4.5%, or a cost of $1,054.40.
The appended table (Mathematics of Amortization) shows what portion
of the cash interest is to be regarded as net interest income or yield
and how much as reduction of the principal of the investment (amortization
of the premium). The
yield is determined by multiplying the book value, which in the first
instance is the purchase price, by the predetermined yield or basis rate,
4.5%. The net income for
September 1, 1978, therefore, is determined by multiplying $1,054.40 by
2.25% (the semiannual rate). This
is $23.70. The difference
between $23.70 (y8ield or net income) and $30.00 (cash interest) is $6.30,
which is the first amortization installment to be applied in the reduction
of the book value of the investment.
The new book value for September 1, 1978, is the difference between
$1,054.40 and $6.30, or $1,048.10.
Since the book value is constantly being reduced, the net income
for such subsequent interest periods declines.
It will be seen that the total of the amortization is equal to
the premium and that provision has been made to extinguish it completely. The
entry on the book for the first interest period should be as follows:
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