Amortization refers to the process of spreading the cost of an intangible or tangible asset with useful life over a period of time. It is used in accounting and finance to allocate the initial cost of the asset over the expected useful time.
What is amortization?
Amortization is a financial concept that involves the gradual reduction of spreading out of the cost of an intangible asset over a period of time. The primary contexts in which amortization is used:
- Loan amortization
- Intangible asset amortization
- Loan amortization: When individuals or businesses borrow money they typically agree to repay the loan in regular installments, which involves both principal and interest. The process of spreading out loan payments over time is known as loan amortization.
- Intangible asset amortization: In the context of intangible assets, like trademarks, copyrights, or goodwill, the cost of acquiring or developing these assets is allocated over their estimated useful life. This allocation of cost over time is known as intangible asset amortization.
Why is amortization important?
Some key reasons why amortization is important:
- Accurate financial reporting
- Asset valuation
- Debt management
- Decision-making
- Compliance with accounting standards
- Investor confidence
- Accurate financial reporting: Amortization ensures that the cost of intangible assets is properly recorded over a period of time, which results in more accurate financial statements, reflecting the true value of assets and providing stakeholders with a clear understanding.
- Asset valuation: Amortization helps maintain a realistic valuation of intangible assets on the balance sheets, as the asset’s cost is gradually expensed over time, the carrying value of the asset decreases, reflecting its diminishing value as it is used or becomes obsolete.
- Debt management: For loans and other forms of debt, amortization ensures that borrowers make regular and structured payments to repay the principal and interest over a varied period of time. The systematic approach helps borrowers manage their debt more effectively and plan finances accordingly.
- Decision-making: Managers and executives rely on proper financial information to make informed decisions. Amortized financial statements provide a clearer image of an organization’s financial health and guide structure.
- Compliance with accounting standards: Following a standard amortization practice allows compliance with accounting standards and rules, promoting consistency and comparability in reporting.
- Investor confidence: Accurate amortization demonstrates transparency and proper financial management. Investors and stakeholders are more likely to have confidence in an organization that presents its financial statements in a clear, and compliant manner.
What is negative amortization?
Negative amortization occurs when the primary balance of loan increases rather than decreases over the time. It is a financial situation where the borrower’s loan payments are not sufficient to cover the interest due, resulting in the unpaid interest being added to the principal balance.
What are advantages and disadvantages of amortization?
The advantages of amortization are as follows:
- Reliable expense allocation
- Better budgeting and planning
- Tax Implications
- Reliable expense allocation: Amortization allows for the proper allocation of teh costing of the intangible assets or the repayments of the loans over its useful life. This ensures that expenses are matched with the periods in which the asset generates economic benefits or the loan provides value to the borrower.
- Better budgeting and planning: Amortization helps organizations forecast cash flows more efficiently, knowing the fixed payment amounts for loans on the gradual reduction of the asset costs over time allows for better financial planning.
- Tax Implications: Amortization affects an organization’s taxable income by reducing taxable profit, as it leads to lower tax liability, helping organizations manage their tax obligations.
The disadvantages of amortization are as follows:
- Increased costs for borrowers
- Impact on profitability
- Increased costs for borrowers: In the case of negative amortization, borrowers may come across future payments or delayed loan payments. This could lead to higher costs over a period of time.
- Impact on profitability: Amortization expenses reduce reported net income, which may impact on organization’s short-term profitability. It is necessary to recognize that amortization is a non-cash expense, and the asset’s economic benefits are realized over its useful life.
What does amortization of loan mean?
Amortization of loan is a process of spreading out the repayment of loan over a specific period through fixed payments. Each payment involves both principal and interest, with the goal of repaying the loan by the end of the term. The process of amortization ensures that the borrower gradually reduces the outstanding balance of the loan over time.
When you take out a loan like, mortgage, can loan or personal loan, the lender provides you with a specific amount of money.
Amortization vs. depreciation: Difference between them
Amortization is used for intangible assets with a finite useful life, intangible assets subject to amortization involve patents, trademarks and goodwill. Intangible assets are non-physical assets that provide long-term economic benefits to the organization and their value typically derives from intellectual rights and zero physical substance.
Whereas depreciation is used for tangible assets like buildings, machinery, vehicles, equipment and furniture that have a limited useful life and are subjects to wear and tear. Tangible assets have a physical form and can be seen and touched, also used for day to day operations of the business over a long period of time.
Employee pulse surveys:
These are short surveys that can be sent frequently to check what your employees think about an issue quickly. The survey comprises fewer questions (not more than 10) to get the information quickly. These can be administered at regular intervals (monthly/weekly/quarterly).
One-on-one meetings:
Having periodic, hour-long meetings for an informal chat with every team member is an excellent way to get a true sense of what’s happening with them. Since it is a safe and private conversation, it helps you get better details about an issue.
eNPS:
eNPS (employee Net Promoter score) is one of the simplest yet effective ways to assess your employee's opinion of your company. It includes one intriguing question that gauges loyalty. An example of eNPS questions include: How likely are you to recommend our company to others? Employees respond to the eNPS survey on a scale of 1-10, where 10 denotes they are ‘highly likely’ to recommend the company and 1 signifies they are ‘highly unlikely’ to recommend it.
Based on the responses, employees can be placed in three different categories:
- Promoters
Employees who have responded positively or agreed. - Detractors
Employees who have reacted negatively or disagreed. - Passives
Employees who have stayed neutral with their responses.
Where do amortization expenses go?
Amortization expenses are recorded in the income statement as operating expenses. The income statement, also known as profit and loss statement (P&L), is a financial statement that shows an organization’s revenue, expenses, and net income or net loss over a period of time, maybe a quarter or a year. Amortization expenses are included in the operating expenses section of the income statement, along with other expenses such as salaries, rent, utilities, and other expenses.
How is amortization calculated?
The amortization is calculated as:
- Identify the cost
- Analyze useful life
- Calculate annual amortization expenses
- Record amortization expenses
- Refreshed Carrying value
- Identify the cost: Identify the total cost or acquisition cost of the intangible asset. This includes all costs associated with acquiring, developing, or registering the asset, such as purchase price, legal fees and miscellaneous expenses.
- Analyze useful life: Estimate the asset’s useful life which is the period over which the asset is expected to generate economic benefits for the organization. The useful life is usually based on legal, contractual, or technical limitations.
- Calculate annual amortization expenses: Divide the total cost of the asset by its estimated useful life. The result is the annual amortization expense.
Annual amortization expense = Total cost of asset / Estimated useful life
- Record amortization expenses: Record the annual amortization expenses from the original cost of the asset to calculate the asset’s carrying value or the book value for each accounting period.
- Refreshed carrying value: Subtract the cumulative amortization expenses from the original cost of the asset to calculate the asset’s carrying value or book value for each accounting period.
Carrying value = Total cost of asset - Cumulative amortization expense
