You'll have to get familiar with a broad range of accounting terms and accounting formulas within your role as a small business owner or an employee of a company. One of them is amortization.
"Amortization" describes two major business processes: the amortization process for loans and the amortisation of assets. We'll look at the significance of both kinds of amortisation.
We'll also discuss the process of calculating amortisation swiftly and effortlessly. This article also highlights the definition of negative amortization.
Before anything else, take a look at our explanation of the term "amortization" in accounting.
Did You Know?
Accountants employ amortisation to distribute the asset costs over the asset’s useful lifeline. Moreover, the IRS has a schedule which displays the entire number of years in which to cost tangible & intangible assets for the purposes of tax.
Also Read: 3 Golden Rules of Accounting - Golden Rules of Accounts Explained with Examples
Why is Amortization important?
If we define amortization, it is necessary to understand three things fundamentally: The initial value of an asset, the useful time left in the asset and the value that remains that the property has. Did you get those numbers? If not, this is how you determine the amount of amortization needed for assets:
- First, you must subtract the residual value from your basis price (the sum you spent on it).
- Divide the figure by the remaining time in its usable life.
- Now you should have the amount of time you could pay off.
Also, the other method easier than manually doing it is to use an amortisation calculator.
What Is Amortization and How Does It Work?
The most valuable assets depreciate as time passes. Amortization allows you to quantify the small losses in your financial documents. It shows the decline in the book value of an asset, which will reduce your tax-deductible income.
If an asset earns cash for more than a year, it is best to reduce the expense over a longer time. It's possible to use amortization to match the asset's cost to the amount it earns every year.
The term "amortization" also refers to the repayment of a principal loan over the loan time. In this scenario, amortisation refers to dividing the loan amount into instalments until it is completely paid off. You should record each payment as an expense and not the total amount of the loan all at once.
Example of Amortization
To understand amortization meaning, let’s know about its examples. It is crucial to manage intangible assets and principles of loans. Check out the following examples of amortization.
The Process of Amortizing an Intangible Asset
You hold a patent on the machine, valid for 30 years. It costs you ₹30,000 to create and design this device (the initial price of the patent). You must record ₹1000 each year to be an amortisation cost to the patent (₹30,000 / 30 years).
Amortizing the Loan
You have a loan of ₹10,000 in the balance. If you pay ₹1000 of principal each year, then ₹1,000 of the loan has been amortised every year. It is recommended to record every year in your accounts in the form of an amortisation charge.
Also Read: Understand Cash Accounting - Cash Account Meaning, Advantages And Limitations
What Is Negative Amortization?
When a business decides to take out a loan, it's important to understand its negative amortization. Negative amortization may make sense when a business borrows money for a specific purpose, like a house flip.
Negative amortisation allows the investor to maintain cash reserves for future investments or improvements. For example, a bookstore with a ₹7,000 debt might choose to refinance it, replacing it with a ₹7,000 loan at 3% interest. That lower interest rate can help the company pay off the loan faster.
The negative aspect of negative amortization is that the lender adds interest to the principal amount owed, so the loan balance increases. Usually, a borrower will have to pay more interest than the standard monthly payment for negative amortization to occur. If the payments aren't enough to pay off the loan on the original schedule, this can be a problem. Fortunately, there are many ways to deal with negative amortization.
The first thing to understand is how negative amortization works. In short, negative amortization allows the borrower to borrow more money for a shorter time period. While negative amortization is not always bad, it can also be dangerous. Unless you borrow a large amount, you should avoid negatively amortising a loan.
What Does Amortization Mean for Intangible Assets?
Amortization of an intangible asset is a procedure in which the value associated with an intangible investment decreases over a certain amount of time. It is called the expected life of its usefulness. The most common definition of "intangible" is "without any physical substance". Intangibles do not possess physical form but are beneficial to an organisation.
Amortization of Intangible Assets
It's possible to use the amortisation of assets for two different purposes: The first is to be used for tax deferment, and the second one for accounting purposes.
The method of amortization employed for these two reasons differs from one another. If used for tax-related purposes, the actual duration of the asset is not assessed, and only the base cost is amortized over an agreed-upon amount of time.
Intangible assets aren't physical in nature, and consequently, determining their actual value isn't as simple as it is for tangible assets. Some rules classify certain assets into those of the intangible category and provide particular importance.
A Sample Method of Calculating the Amortization Process for an Intangible Asset
Let's say that a business has created a software application to use internally to help control its stock. The company doesn't intend ever to offer this software, and it's intended for use by its employees. The software is regarded as an intangible asset, and it has to be amortised throughout its time.
The company must first be able to record the cost of creating the software in the balance sheet of its financial statements as an intangible asset. The software costs the company ₹10,000 in this instance.
The company is also estimating that the software will have a useful life of three years, given the rapid speed of technological advancement. After 3 years of operation, the firm believes that its internal software will be zero value. Therefore, its value as a residual asset is zero. The company will further use the straight-line method of reporting software amortisation.
Subtracting the residual amount minus zero - from the recorded ₹10,000 cost and then dividing it by the program's three-year functional duration, the company's accountants calculate the annual amortisation of the software to be ₹3333.33. Every year the net asset value for the software will decrease by this amount, while the firm will be able to report an amortization cost of ₹3,333.33.
Amortization vs Depreciation: What's the Difference?
After you know the amortization definition, let's know the difference between Amortization vs Depreciation. Amortization, as opposed to depreciation, is among the most baffling topics in this subject because both procedures seem to describe the same things.
While amortization and depreciation are methods for estimating the costs of your company's capital assets, each has an important distinction that sets them apart from the other. It's all about the kind of asset being charged.
Amortization is usually used to finance intangible assets, i.e. things that aren't physically tangible, like trademarks, trade names, copyright, etc.
On the other hand, depreciation is used to describe fixed assets, which are also called tangible assets. Tangible assets are physical, including real estate, equipment and automobiles.
Why Is Amortization Important in Accounting?
If we talk about the concept of amortization meaning in accounting, it is often applied to loans for businesses with intangible assets.
Both tangible and intangible assets have a finite useful life. Intangible assets also have obsolescence and expiration dates. Amortization is the process of allocating value to these assets. Just as tangible assets depreciate over time, intangible assets also wear out.
The cost is usually spread out over many years when a business buys a fixed asset, and this is because the asset is expected to produce income for some years. For example, a business might purchase an office building and later move to a larger, more efficient one.
However, the original building could be old and rundown. Because of its expected lifespan, the cost of the building is amortised over time, allowing the company to expense a portion of the cost each year. Amortization is a concept used by accountants to spread the cost of intangible assets over time.
In amortisation, an intangible asset is gradually written down over time. The purpose is to reflect the true benefit of a large expense over a long period. This allows companies to reflect more accurate costs of doing business and allow the benefits to continue long after the initial expense is reported. The term "amortization" can also refer to the depreciation of tangible assets.
Conclusion
Amortization expense is reported as the cost implemented on the account books of an organisation that results in profits. In simple words, there'll be lower taxes implemented for those businesses.
If you're aware of amortization, it will be beneficial in accounting as it's among the top accounting terms. Also, integrating platforms such as Khatabook for keeping all the income & expenditure calculations handy can help you a lot.
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