What is amortization in accounting, and how is it calculated?
What is amortization in accounting and should small business owners worry about amortization even if they don’t have practical assets?
The answer is: yes. All business owners should consider amortization during accounting because the definition of an asset in itself is fluid.
Some assets don’t have a physical form. It can be your brand value, R&D inventions, business secrets, or intellectual properties you own.
During any accounting exercise, you must evaluate the values of these assets — every year. Moreover, this value will not stay constant. Compare your assets to an inflated balloon.
Just like how a balloon deflates over time, your assets lose some of their worth too. Sometimes they can even expand. Either way, their value holds a financial significance and must not be ignored.
Every asset has an initial value when its bought. However, it doesn’t stay the same throughout its lifetime. Amortization, in general, is writing off a part of its value every year.
In other words, it means spreading out the value of an intangible asset over its lifetime. This is also applicable to loans whose book value reduces over the years through fixed and varied interest rates.
It is hard to write in numerical terms the value of intangible assets, especially something like goodwill that doesn’t have a practical use.
But there are ways to put a number to it, and your accountants must take that into consideration when filing the annual expense records.
Now you might be wondering: how is amortization different from depreciation? Well, for the most part, they both are the same. There is just one difference.
Amortization is for measuring intangible assets’ value, and depreciation is for tangible assets.
So, for example, the brand value of a company logo or mascot may be amortized, while the resale price of their manufacturing machines may depreciate.
Amortization in accounting is the process of expensing an asset’s value over the period of its useful life in your balance sheet.
So, the cost required to procure or manage the asset is recorded in the expense sheet rather than the income statement. By decreasing the assets’ value, you thereby reduce the taxable income.
Here is an example of an amortization value entry in a journal.
A company buys a trademark for $10,000 that’s valid for five years, after which it will be leased out or sold to someone. The amortization expense entered in the books will be $2000 per year — i.e, the value of the trademark acquisition is evenly distributed across its lifetime (while in your ownership).
At the same time, any accumulated amortization is added to the credit side of the journal. This is how amortization value impacts the business expenses.
Amortization in accounting is a simple process with a few steps. But these few steps have a rather big impact on your financial value. Amortization is important to calculate the taxable income for a certain period.
By accounting for your amortization costs, you can reduce tax liabilities. A spread-out expense (or borrowing) gives a clear perspective to both finance teams and management about expenses and income. There are plenty of other benefits too.
Though assets generate value, they also incur maintenance costs. Accurate estimation of these expenses is essential for expense forecasting.
An agile finance team will be prepared not just for current expenses but for the future too. With amortization’s help, you will know how much you will incur in the future because of your loans and assets.
If you don’t include amortization costs while budget planning, your cash flow will take that hit in later periods.
If you make an expense that’s not included in your balance sheet, it will be trouble later during reconciliation. While matching your bank statement with balance sheets, you will find discrepancies.
This is because the costs incurred for intangible assets are not always direct. To avoid the missing cost record being perceived as fraud, amortization values must be formally recorded.
Once you subtract the expenses and discounts from your revenue, you get the net revenue. This is where a company pays dividends to its stockholders. Including amortization in the expenses list will reduce the net revenue.
Consequently, you will see a reduction in stockholders’ equity too. Also, your retained earnings (net income - dividends share = retained earnings) will go up, too, as stockholders' share has decreased.
Having fixed loan repayment dues help in expense forecasting a lot. As the due amount is the same throughout, expenses can be planned better ahead, leading to smooth and timely repayments.
Amortized loans are slightly different from regular bank loans. Although most bank loans have similar payment dues, amortized loans spread out equally during the payment period.
It’s structured so that you will pay the interest portion during the early duration and the principal part later. To get this clear understanding of the way your bank collects dues, amortization helps a lot.
Investors and managers pay attention to the above part specifically to understand the company’s financial position and liabilities.
There is a mathematical formula to calculate amortization in accounting to add to the projected expenses.
P = r(PV) / 1-(1-r)^to the power of -n
P = Periodic payment amount of the asset or a loan
r = Rate of interest
PV = Present value
n = Number of periods (or) duration
Amortization of an intangible asset = (Cost of asset-salvage value)/Number of years the asset can add value.
Salvage value - If the asset has any monetary value after its useful life.
The above figures are a little daunting if you look at them as is, so here is an example to demonstrate it. This is mainly used to calculate the amortization schedule of a loan.
Let’s assume that a company has taken up a business loan of $5M for business expansion. The value ‘P’ represents the period in months when you repay the loan.
If the repayment period is five years, then you will pay $1M each year. There is a rate of interest of 5% too, which is $50k every year. Summing it up, you will pay $105,000 every year to amortize the loan.
Let’s consider the amortization schedule of an intangible asset. Suppose your company creates software for internal use. Its infrastructure can only support you for a three years period.
If it took $30,000 to create the software, and the salvage period can be considered zero as the software will not be useful after three years, then:
Amortization expenses of the software = (30000 - 0)/3 = $10000.
Smart companies are keen on making accurate expense projections. They also want to reduce their tax liability and increase their retained earnings. That is only possible if you count every single expense, direct or indirect.
Amortizing costs is the best way to do that. Amortization in accounting also sets guidelines to handle intangible assets effectively. It’s often neglected as it involves manual calculations and complicated formulas.
But, the important point is amortization expenses must be carried out to gain clarity over expenses.