What is Amortization?
Amortization is the process of spreading out the cost of a debt or asset over a period of time.
When used in the context of debt, it is the process of paying off a debt over time through regular payments. It involves dividing the total amount of the debt into smaller, manageable payments, which are spread out over a fixed period.
When used in the context of an intangible asset, it is also used to refer to the process of gradually reducing the value of an intangible asset, such as a patent, trademark, or goodwill, over time.
This is because intangible assets, unlike tangible assets, do not have a fixed physical lifespan and can potentially provide value to the company indefinitely.
Amortization of Loans
In the case of a loan, the principal is divided by the number of payments to be made including interest to be paid for the loan.
Amortization of loans refers to the process of paying off a loan through a series of regular payments over a fixed period of time. Each payment is made up of both principal and interest, with the principal increasing and the interest decreasing over time.
In a typical amortizing loan, each payment includes both principal and interest. The interest is calculated based on the outstanding balance of the loan at that time, while the principal is the amount still unpaid.
Since interest is calculated on the outstanding unpaid balance, the first few loan payments will consist mostly of interest payments, with only a small portion going towards paying off the principal.
Over time, the principal included in each payment will gradually increase, while the interest will gradually decrease, until the loan is fully paid off.
Amortization of loans allows borrowers to repay debts in regular, manageable installments, while lenders earn interest on the outstanding balance over time.
Amortization of Assets
Amortization of assets is the process of spreading the cost of an intangible asset over its useful life. Intangible assets do not have a physical form, such as patents, copyrights, trademarks, and goodwill.
The entire cost of an intangible asset is not counted as an expense in the year it is acquired. Instead, its cost is spread out over its useful life by amortization.
|What is an asset’s useful life?
The amount of time the asset is expected to bring economic value to the business is its useful life.
Let’s take the example of a pharmaceutical company with a patent on a fever medication. This patent means that no other company can make that particular drug – the entire market is accessible only to this pharmaceutical company.
In India, pharmaceutical companies can hold a patent for 20 years. This means that the patent for the fever drug will give the company economic value for the next 20 years.
The cost of using tangible assets is spread out as well, in a process called depreciation.
Read more: Depreciation
How to Calculate Amortization
Amortization for Loans
The formula to calculate the amortization for loans is:
Monthly Payment = (Loan amount x monthly interest rate) / (1 – (1 + monthly interest rate)^number of payments over loan term)
Monthly interest rate is calculated by dividing annual interest rate by 12.
This formula will give you the amount that has to be repaid every month to fully amortize the loan by the end of the term.
Amortization of Assets
The formula for amortization of an intangible asset is:
Annual Amortization Expense = (Cost of Asset – Residual Value) / Estimated Useful Life
The “residual value” of the asset is the expected value of that asset at the end of its useful life.
This formula helps companies divide the cost of the asset over its useful life. This divided cost is then recorded as an expense in the company’s accounting records.
The expense reduces the value of the intangible asset on the balance sheet each year till it reaches its residual value at the end of its useful life.
An amortization schedule is used to keep track of payments made towards a loan, and as a way for the lender and borrower to communicate. It is also used by companies to track the value of an asset over its useful life.
Let’s look at the amortization schedule for a machine purchased for Rs 1,00,000, which has an estimated useful life of 5 years, and a residual value of Rs 10,000 at the end of 5 years.
|Year||Beginning Balance||Amortization||Ending Balance|
|1||Rs 100,000||Rs 18,000||Rs 82,000|
|2||Rs 82,000||Rs 18,000||Rs 64,000|
|3||Rs 64,000||Rs 18,000||Rs 46,000|
|4||Rs 46,000||Rs 18,000||Rs 28,000|
|5||Rs 28,000||Rs 18,000||Rs 10,000|
Amortization vs Depreciation
Both amortization and depreciation involve the allocation of an asset’s cost over its useful life, they are used for different types of assets and may use different calculation methods.
|Definition||Allocation of the cost of an intangible asset over its useful life.||Allocation of the cost of a tangible asset over its useful life.|
|Asset Type||Intangible assets such as patents, copyrights, and trademarks.||Tangible assets such as buildings, equipment, and vehicles.|
|Calculation Method||Generally, amortization is calculated using the straight-line method, where the cost of the asset is spread evenly over its useful life.||Depreciation can be calculated using various methods, including the straight-line method, declining balance method, and sum-of-the-years’ digits method.|
|Salvage Value||Often, intangible assets have no salvage value at the end of their useful life.||Tangible assets may have a salvage value, which is the estimated value of the asset at the end of its useful life.|
Importance of Amortization
Amortization is the best way to account for the value of a loan or asset over a period of time. It would be mathematically incorrect to account for the entire value of a loan or asset the moment it is acquired.
By writing down and maintaining a detailed schedule of payments or value deductions, the company has insight into its future position in terms of assets or debt.
Whether it’s for loans, intangible assets or other assets, amortization helps individuals and businesses better manage their finances and plan for the future.
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Can the amortization period of a loan be changed after it has been set?
Yes, it is possible to change the amortization period of a loan, although it may come with certain restrictions or fees depending on the terms of the loan agreement.
What happens if an asset is fully amortized before the end of its useful life
If an asset is fully amortized before the end of its useful life, it means that the entire cost of the asset has been allocated to the company's expenses. At this point, the asset will no longer appear on the company's balance sheet and any remaining value of the asset will need to be written off.
How does amortization differ from depletion?
Amortization and depletion are similar concepts in that they both involve the allocation of an asset's cost over its useful life. However, depletion is specifically used in accounting for natural resources, such as oil, gas or minerals, and involves the gradual reduction of the asset's value over time as it is extracted or used up. Amortization, on the other hand, is used for intangible assets and tangible assets that don't fall under the category of natural resources.