All About Amortization


What is amortization?

Amortization refers to an accounting process of repaying debt through pre-determined instalments comprising principal and interest. It is a technique to lower the book value of an intangible asset or a loan over a preset duration. Basically, through amortization, you can spread out loan payments over a period of time.

Though your monthly payment remains the same throughout the duration, it is divided among interest costs, thus reducing your loan balance and other expenses, such as property taxes. Amortization helps you calculate your outstanding balance and interest costs and thus, makes you comprehend how loan repayment works.

KEY TAKEAWAYS

  • The concept of amortization is helpful to account for the expenses required to produce revenue while using the intangible asset’s value.
  • Remember, you cannot amortize a tangible asset.
  • Amortization schedules are often used by financial institutions to depict a loan repayment basis on a specified maturity date.
  • The amortization schedule breaks down on the basis of how much of both the principal and interest amounts have been allotted to each periodic payment.
  • When the repayments of a loan amount are lower than its accumulated interest, it may turn out to be negative amortization causing the borrower to owe more money.

In terms of loan repayment, amortization provides clarity about what portion of a loan comprises principal versus interest. So, you can easily calculate interest payments for tax purposes in advance. It helps investors and businesspeople forecast loan costs over a set duration. What’s more? Amortization of intangible assets can reduce an organization’s taxable income and hence, their tax liability, which ultimately helps investors get a better understanding of the organization’s actual earnings.

Loan Amortization Schedule

A schedule of loan amortization is the table of pre-installed loan payments in which each level payment comprises the amount of both principal and interest until the loan amount is completely paid off at the end of its tenure. So, it features level payments till the life of the loan. However, each proportion of principal and interest may vary. During the early phase of the loan repayment, most of the payment may go towards interest, while the later phase may cover the remaining principal amount of the loan. A traditional mortgage is one of the best examples of such a loan.

Amortization vs Depreciation

Amortization and depreciation are the two primary methods of determining the value of business assets. The cost of these assets is expensed each year, and then it’s used to reduce the tax liability of the business via a tax deduction. Remember that a tangible asset has some scrap or salvage value even at the end of its useful life, while an intangible asset does not have such value; therefore, their formulae show the difference.

Annual Amortization = (Cost of Intangible Asset)/Useful Life

Amortization refers to the decreasing value of an intangible asset over a period of time. It applies to assets, such as patents, trademarks, intellectual property, and other similar intangible assets. While depreciation refers to the decreasing value of a tangible asset, such as plants, vehicles, machinery, buildings, equipment, property, and other assets that an organization owns.

For example: An organization has been granted a maintenance contract for ₹10 Lakh which will be recovered over 10 years.

Annual Amortization= (Cost of Intangible Asset)/Useful Life

Annual amortization = 10/10

Annual amortization cost = ₹1 Lakh

Annual Depreciation = (Cost of Tangible Asset-Salvage Value)/Useful Life

For example: An organization purchases a piece of equipment that has a useful life of around five years. The salvage value at the end of these five years is around 10% of the original purchase price.

Annual Depreciation = (Cost of Tangible Asset - Salvage Value)/Useful Life

Asset cost: ₹10,000

Salvage value after five years: ₹10,000 x 10% = ₹1,000

The difference between the asset cost and the residual cost = ₹10,000 - ₹1,000 = ₹9,000

Thus, annual depreciation = ₹9,000 / 5 = ₹1,800

Thus, annual depreciation = ₹9,000 / 5 = ₹1,800

Applicability: The main difference between amortization and depreciation is their applicability. Amortization applies to an organization’s intangible assets, while depreciation applies only to the tangible assets of the organization.

Implementation: Depreciation calculation may vary for each asset. For some assets, depreciation is applicable at a steady rate over the year, and thus, the straight-line method (SLM) of calculation is ideal for them, while other assets may depreciate at an accelerated rate in the early years and therefore, they depreciate slowly. However, amortization is often calculated by using the straight-line method.

Residual value: A tangible asset has a residual scrap or salvage value at the end, while an intangible asset does not have such value, and thus, the difference between the two methods of calculation.

Purpose: The purpose of amortization is to capitalize the cost of the business assets over a period of time, while depreciation is all about spreading out the asset cost till the duration of its useful life. It is useful for attaining some tax benefits.

Amortization vs Impairment

Amortization: Amortization refers to the declining value of an organization’s intangible assets, such as copyrights, patents, goodwill, etc. According to the accrual principle of accounting, it is mandatory to use assets cost as an expense over their useful life. Amortization is hence used to deduce the fair market value of such assets. The cost of an amortized asset is prorated over its useful period to show its fair value.

Impairment: Impairment, on the other hand, depicts the declining value of a fixed asset due to some unforeseen circumstances. An asset is impaired when its carrying value increases over its real market value and needs to be written down, which eventually turns out to be an impairment loss. An asset can be impaired due to numerous reasons, such as becoming obsolete, changing market conditions, damages to the asset, failing to meet regulatory standards, etc. Companies are supposed to conduct regular tests and then write off any asset as impaired. Once an asset has been declared impaired, there is a very low probability for it to be written up again.

Now, let’s go through the differences between the two:

Amortization Impairment
Amortization is a decline in the value of an intangible asset over its useful life. In the case of impairment, the value of an asset decreases due to some unforeseen circumstances.
Amortization is shown as an expense on the balance sheet. It is shown as an impairment loss.
Amortization is calculated annually. There is no such annual charge in case of impairment.
Amortization is a continuous process, for the value of an intangible business asset reduces over a period of time. Here, the value of an asset reduces drastically, which requires it to be written down to its fair market value.
Amortization of an asset happens due to obsolescence, consumption, etc. Impairment can happen due to changes in preferences, damage to the asset, etc.
Amortization is mainly applicable to intangible assets. Impairment applies to fixed assets, whether tangible or intangible.

Benefits of Amortization

If you want to understand how borrowing actually works, then first try to grasp what amortization is. Before buying an asset, people often make decisions by determining the monthly payment. However, interest costs serve as a better way to find out the real cost of your purchased asset. Often a lower monthly payment means you will be paying off the amount more in interest because you stretch out the repayment duration. With the help of an amortization table, it is easier for you to estimate different loan options available in the market. You can easily compare interest rates provided by different lenders and evaluate your savings and refinancing options.

Amortization of a Loan vs Amortization of Assets

Amortization of a Loan: The amortization of a loan refers to the process of paying off the outstanding debt in full over time. When a loan amount is granted, the borrower is supposed to meet a series of fixed payments established at the outset. Though the payment amount remains the same throughout the duration, the bifurcation of the principal and interest may vary from one month to another.

Amortization of Assets: Amortization of assets, however, is the act of periodic deduction of intangible assets, such as branding, trademarks, goodwill, etc. Thus, it is more challenging to evaluate because their true cost is not fixed

Nevertheless, whether referring to the loan amortization or the amortization of an asset, it denotes the periodic deduction of the book value over a set duration. In case you are blessed to have an accountant officer with a solid understanding of your company, the process of amortization can become simpler to implement.

Final words

Comprehending the concept of amortization can really help you evaluate different options, whether in terms of a loan or an intangible asset, in the market, so you can see the bigger picture. It helps you compare different options. Amortization and depreciation are the two methods of evaluating the value of business assets over a period of time, while impairment of an asset (whether tangible or intangible) happens due to some unforeseen circumstances.

Other Words

  • Annual Percentage Rate

Apply for A Loan

Business Loan Logo

Business
Loan

Business Loan Logo

Business
Loan

Professional Loan Logo

Professional
Loan

Professional Loan Logo

Professional
Loan

personal loan Logo

Personal
Loan

personal loan Logo

Personal
Loan

Car Loan Logo

Pre-Owned
Car Loan

Car Loan Logo

Pre-Owned
Car Loan

Medical Equipment Loan Logo

Medical Equipment Loan

Medical Equipment Loan Logo

Medical Equipment Loan

Machinery Loan Logo

Machinery Loan

Machinery Loan Logo

Machinery Loan

Loan Against Property Logo

Loan Against
Property

Loan Against Property Logo

Loan Against
Property

Apply for A Loan

Contact Us logo Quick Apply CIBIL Score logo Free CIBIL Whatsapp logo Connect on WhatsApp