Basic Principle of Amortization
Accounting is the process of recording economic activity and reporting this information in a timely and accurate manner. Basically the information should be fairly stated in the financial reports. When a loan is acquired; lending institutions have fees and loan costs they customarily pass to commercial enterprises. Often these fees range from two to six percent of the loan’s principle. For a $10,000 loan two hundred to six hundred dollars in fees will not greatly affect the income statement results. However, a $100,000 loan with $4,000 of fees will negatively impact the profit for a small business as reported on the interim financial statement. So GAAP requires a two step process to address this situation.
The first step is to record the cost to the balance sheet as an intangible asset. The second step is to amortize the total costs over the life of the loan.
Step 1 – Record as an Asset
The asset side of the balance sheet is divided into three major groups of assets; current, fixed and other. Other assets comprise mostly intangible assets. Financing costs are initially recorded as an intangible asset.
Accountants and bookkeepers must be careful as to what constitutes financing costs. Most loans are straight forward and identify the loan costs in the terms and conditions section of the commitment letter. Often these terms include:
* Loan Origination Fee – usually stated as a percentage of the loan principle
* Lender’s Processing Charge – a flat dollar amount
* Uniform Commercial Code (UCC-1) Costs – A state recording cost assigning collateral to the lender; usually it is no more than $100.
* Court Recording Fee – Often loan documents are recorded at the circuit court requiring a fee to complete.
* Notary and Stamps
* Legal Processing Fee – legal costs for attorney charges
* Prepaid Property Taxes
* Prepaid Insurance
Not all of these costs are considered a function of financing. The two prepaid items are merely regular (protection and ongoing tax) costs that are advanced by the borrower and recorded as prepaid expenses in the current assets section of the balance sheet. Sometimes the stamp cost is merely a tax and can be written off as an immediate expense. The balance of these costs all relate to the actual loan processing and are accumulated as one summed amount called loan financing costs.
In bookkeeping, the debit side of the entry is to financing costs and the credit side depends on the source. In most cases the source is cash, so the credit entry is simple. However, in more complex loans the credit may be the loan itself as the closing costs are funded by the amount borrowed. Some of the costs have to be paid with cash such as credit checks or pre-costs for the loan (survey, engineering reports, legal work-up). These prepaid costs are accumulated as a function of the financing costs of the loan and are recorded to other assets too.
Once all the costs are accumulated it is now time to allocate these costs over time to the income statement (profit and loss statement).
Step 2 – Amortization of Loan Costs
The costs of the loan are allocated over the life of the loan. The loan document states the life usually in months. Most loans have a definitive period of time such as 84 months (7 years), 120 months (10 years) and so on. However most if not all lending institutions use a risk reduction feature referred to as a ‘call’ or ‘balloon’ provision. This allows the lender to amortize the principle over a longer period of time but force the final balance of principle payment earlier.
It is rare to have a call or balloon period in excess of seven years. Banks consider anything longer to risky as interest rates could change dramatically in the interim. GAAP sets the amortization period to the expected life of the loan which means the call or balloon date. For illustration purposes, seven years is used.
The formula is straight forward for the amortization amount per month:
Amortization of Financing Costs = Total Financing Costs
Balloon Period in Months
So if the financing costs for an equipment loan were $3,782, the amortization amount per month equals:
$3,782 of Financing Costs
84 Months (Seven Years)
Amortization Per Month = $45.02
If the loan is paid off early, any remaining balance of financing costs is expensed (recognized as a cost of business) at that time.
Organization of Information
Accounting information is organized via the chart of accounts. Most accountants structure the intangible section of other assets in a similar fashion as fixed assets. The respective chart of accounts for this section may look like this:
Land Held for Future Use
– Long-Term Receivables
– Prepaid Reserves
– Organizational Costs
– Franchise Fee
– Financing Costs
* Loan # 7210
* Loan # 1171
* Loan # 5057
* Accumulated Amortization
Typically financing costs are set up with a parent-child account structure to simplify reporting. As the entry is made each month for amortization; the debit is made to an income statement expense account and the credit is made to accumulated amortization, not to the original loan financing amount. This allows a reader of financing information to understand how much was incurred for the original closing cost for that particular loan.
Over in the expense section of the income statement accounts amortization has historically been set up as one of the last expense accounts along with depreciation. More modern structures have organized the expenses into major groups such as:
* Management – front and back office payroll
* Facilities – rent, utilities, cleaning and maintenance
* Insurance – general liability, property, indemnity, professional
* Office – technology, supplies, postage, communication
* Taxes and Licenses – local taxes, revenue etc.
* Other – travel, training, auto, meals and entertainment
* Capital Costs – leases, interest, depreciation and amortization
The capital section identifies those costs associated with fixed and other asset costs including financing (interest, leases, amortization) of those costs. This is where amortization is located and where the monthly debit is posted to the ledger. Since amortization is usually in small increments for the various items of amortization (organizational costs, goodwill, legal agreements, financing costs, etc.). It is customarily reported as one summed value.
To understand how much of the financing costs have been amortized and the remaining balance the accountant looks to the reports to interpret the information.
Reporting and Interpretation
Better organized accountants use one of several different methods to log and track information related to amortization. The following are the best tools:
A) Amortization Schedules – Information is tracked in a set of Excel spreadsheets in a similar fashion as depreciation schedules; see Lesson 51 for an in depth explanation.
B) Fixed Asset Module – Most modern day accounting software programs have built in fixed asset modules that produce both GAAP depreciation and amortization schedules. Intangibles are treated just like fixed assets except they are coded with status as intangible. The amortization method is straight line with a mid-month convention. The reports separate fixed assets and intangible assets.
C) A Separate Ledger – Instead of using the structure illustrated in the last section, a single ledger is kept tracking the original cost basis and each of the recurring amortization entries thus identifying the net value as the ending balance in the ledger.
When the information is reported in the balance sheet there are two reporting formats – summary and detail. The summary format presents a single value for the remaining unamortized financing costs referred to as net financing costs as illustrated here:
The detail format presents both the original cost basis and accumulated amortization to date as illustrated below:
Notice in the summary format the term ‘Net’ is used for combining all original cost basis and accumulated amortization. In the detailed presentation format both cost basis and accumulated amortization accounts are displayed. Furthermore, accumulated amortization is identified with parenthesis since it is a credit balance in an asset based type of account. See Debits and Credits in Parenthesis on the Balance Sheet (Lesson 13) for further guidance.
Over on the income statement (profit and loss statement) amortization is reported in the capital costs section of expenses as illustrated here:
Manufacturing and Engineering Inc.
Income Statement (Limited Presentation Format)
For the Month Ending June 30, 2016
Contract Income $Z,ZZZ,ZZZ
Costs of Design/Production ZZZ,ZZZ
Gross Profit ZZZ,ZZZ
Taxes and Licenses Z,ZZZ
Sub-Total Expenses ZZ,ZZZ
– Leases $Z,ZZZ
– Interest Z,ZZZ
– Depreciation ZZ,ZZZ
– Amortization Z,ZZZ
Subtotal Capital Costs ZZ,ZZZ
Operational Profit $ZZ,ZZZ
As illustrated, amortization is typically the last expense account for reporting purposes. This is not a rule but a general practice in reporting expenses.
Most formal sets of financing reports include notes. One of the notes will lay out the respective intangible assets with each account’s cost basis and accumulated amortization to date. Furthermore the notes will identify future amortization over a course of five years and the expected amounts in all years combined after the fifth year. It is important for the reader to understand that amortization of financing costs is by rule * straight-line. There is no accelerated amortization as is possible with other intangibles.
* There are exceptions to this rule, but it is extremely rare and beyond the introductory aspect of this lesson.
One of the worst mistakes made by readers of financial reports is giving value to all intangible assets, specifically financing costs. This particular asset had no real value in any form of liquidation or business valuation purposes. In addition, the amount reported on the income statement is a non-cash expense similar to depreciation. The cash outlay occurred at the inception of the note.
FINANCING COSTS HAVE NO INTRINSIC OR REAL FAIR MARKET VALUE FOR VALUATION PURPOSES. IN ADDITION AMORTIZATION OF FINANCING COSTS IS A NON-CASH EXPENSE.
Widget manufacturing (WM) purchases real estate with a prefabricated building on the property. Total financing by the mortgage company is authorized for $400,000. The following is a list of various costs paid prior to closing and at closing:
The loan agreement is a flat 20 years with no balloon or call provision. How much is the monthly amortization?
To calculate amortization, the accountant must first determine those costs that are directly related to the financing function and not the ownership of the building.
So let’s start with the prepaid costs.
Prepaid costs are typically those costs required upfront to create and investigate the financial attributes of a deal. Notice that there are legal costs to negotiate and create a binding purchasing agreement. This is a function of the real estate costs and not financing. The balance of items in the prepaid column are directly related to the financing agreement. None of the items are required if the deal is a straight cash transaction. However, a caveat to this statement, the buyer can and should pay for an engineering report and an appraisal to gain comfort in purchasing a quality building at a fair price. The costs associated with this under a cash price are included as value of the fixed asset and are depreciated over time. Since these costs are required upfront by the lender and are a requirement to obtain financing; they are now a part of financing costs. Of the prepaid costs, $9,770 are included in the value for financial costs.
At closing several different costs are paid and include these groups of costs:
A) Financial Lender Required – Benefits the lender; these costs are summed up as financial costs (intangible asset).
B) Governmental – Costs that are required regardless of financing.
C) Expenses – Amounts paid for future value or protection of the asset and will be consumed in a relatively short period of time.
D) Asset – Value paid is a function of the asset and is retained with the asset.
So let’s repeat the HUD-1 costs and code each to the respective group identifier.
(A) A survey is generally required for financing purposes. It is not legally required in an outright purchase deal. It is an item that is customarily recorded with land records and a confirmation document is not necessary except to the lender.
(B) Plat/Plans and the site footprint are generally required for both the lender and the buyer. So this cost can be either financing or assigned as value for the fixed asset. Don’t forget, either way it will be expensed over time to the income statement; if aggregated with the fixed asset, depreciation is the method; if included with financing costs, amortization is the tool.
(C) Prepaid items are customarily included as a requirement to obtain financing and used to protect the lender by holding the proceeds in escrow. Each mortgage payment includes additional funds to increase the escrow balance. The lender pays the insurance premiums and real estate taxes as they are due using the escrow funds. Other examples of escrow funds include:
* Tenant Deposits
* Replacement Reserves
* Tenant Prepayments
(D) Often buyers purchase warranties to protect against unforeseen future breakdowns. Warranties are usually not required by lenders and are purchased by the buyer. Warranties are customarily recorded as an other asset and amortized to asset maintenance (in this case in the facilities section of the expense section).
(E) Legal counsel for the buyer is interesting because the buyer needs the legal assistance even without financing. The problem is that a good portion of the fee relates to the legal work performed to review and advise on the loan documents. Some accountants include this value as financing, others pro rate the amount between the asset and financing. Either way it is expensed over time via depreciation or amortization.
(F) Governmental fees and charges can be directly expensed to the income statement or accrued to the fixed asset value. They are not a function of financing.
As identified above, the following are financing costs:
An account is set up under intangibles, financing costs with a subaccount assigned with the loan number (I suggest the last four digits) and the debit value of $30,070 is posted there. The usual offset is a part of the cash brought by the buyer to closing.
Since the loan is twenty years (240 months) the monthly amortization is $125.29.
Some Additional Insight
Often loans are refinanced after several years. At refinancing, any remaining balance in the unamortized financing costs is expended as an unusual one time cost in other expenses. Many accountants advocate accumulating the existing refinancing costs with the original financing costs and recalculating amortization over the life of the new loan. GAAP has rules for both methods, so consult with the company’s CPA for which method to use.
Another variance of this arises if the business sells the asset prior to amortizing the financing costs. In this situation, the unamortized balance is included with the remaining basis of the asset to determine the gain on the sale of the asset.
If you are having trouble applying the above to your situation, I can do the work for you and send you the entry. You simply send me the list of closing costs and the corresponding term of the loan, and I’ll send you back the entry to be made on your books. E-mail me firstname.lastname@example.org to get started. In most cases, my fee will be less than $50 to perform the calculation and create the entry.
Summary – Amortization of Financing Costs
Amortization of financing costs is the process of allocating financing costs over the life of the loan to the income statement. Amortization is charged to one of the accounts in the capital costs section of expenses. Financing costs are accumulated as an intangible asset in the other assets section of the balance sheet.
Not all costs at closing deal directly with financing of the purchase price, but most do. The accountant separates all the costs into four distinct groups; one is financing. The actual loan proceeds are recorded as a long-term liability in the liabilities section of the balance sheet.
The monthly amortization amount is based on the life of the loan. If the loan has a balloon payment date, amortization is calculated based on the balloon time period and not the loan amortization period. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.