Difference Between Accounting and Financial Amortization
In economics there are two meanings of the word amortization, depending on whether it is used from an economic-accounting point of view or from a financial point of view. In other words, one is used to amortize assets and another to amortize liabilities.
The economic-accounting amortization is used to amortize assets. Meanwhile, financial amortization is used to amortize liabilities.
In the following, each of the two concepts will be explained. Explaining each of them in detail.
Difference between accounting and financial amortization
Next we will see the difference between financial and accounting amortization:
- Accounting or economic depreciation: When a company buys an asset, it uses it during a specific useful life. For example a van that lasts ten years. For this reason, it tries to distribute the cost of that van over the ten years.
We can understand accounting amortization as the reserve of money that accumulates year after year in order to recover the initial investment before it can no longer be used due to reaching the end of its useful life. With this reserve, the company will be able to face the investment involved in getting rid of the current machine and acquiring a new one to replace it, once the current machine stops being useful or working.
- Financial amortization: It refers to the part of the fee 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 amortization (principal payment) and another is a financial expense (interest payment).
Fee = Principal + Interest
Let's imagine that you have requested a loan from the bank for €10,000 (principal), and in the current month you have to pay a fee to the bank of €1,000, of which €800 correspond to the payment of the principal (amortization of the principal) and €200 € to the payment of interest. This means that the value of the principal that you still owe the bank will become €9,200 (10,000 – 800), and the other €200 of the installment payment would be the financial expense. In conclusion, you would have amortized €800.
Example of accounting and financial amortization
At this point we are going to 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 straight- line accounting depreciation each year the machine will be $2,000 less in 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 in order to acquire a certain warehouse to manufacture the bottles, we ask for a loan. The value of the loan is $50,000. The financial amortization refers to the payment of the debt that we are making. When we write off debt, what we are saying is that we are "paying" it. Amortization always refers to the principal and does not take interest into account.