What is Amortization and How is it Calculated?

To calculate the value of assets we use two approaches- One is Depreciation and the other one is Amortization. There is yet another method, but it is not so common. It is called Depletion.

 

The cost of assets are allocated over their useful life and the expense is then adjusted against tax to get tax deduction thereby reducing tax liability. In this blog you will get detailed information about the concept of Amortization.

 

What is Amortization?

 

We have two different types of assets in business. One that we can touch and feel, they are tangible assets. The other one that we cannot touch or feel are intangible assets. Both these assets have to be brought down to their values in order to find the book value.

 

To calculate this value we use different approaches. Amortization is a practice in which we calculate the value of intangible assets by allocating its cost over the useful life. We basically use SLM in amortization. SLM stands for Straight Line Method. In this the amount allocated each year remains constant.

 

Accounting Standard- 26, talks about Intangible Assets and its treatment. Later on after IND-AS came into effect the standard changed to 38. But nonetheless, the main idea is that this standard talks about Amortization of such assets.

 

 

Examples of assets that are Amortized

 

Given below are some of the intangible assets that are amortized to calculate the value of the asset.

 

• Trademarks

• Patents, Softwares

• Copyrights

• Organizational costs

• Cost of bonds for raising capital

 

But intangible assets like Goodwill cannot be amortized if it has an indefinite lifespan. The basic idea behind amortizing is to find the value of gradual decrease of your asset.

 

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Is Repayment of loan also called Amortization?

 

Yes, when you repay the loan over the period the amount you pay is also amortization. In this case amortized amount is calculated by dividing the loan amount into multiple payments until the final principal amount is paid. Each payment you make will count as an expense.

 

The formula to calculate the amortization of loan is given below:

 

A=Pr(1+r)n/(1+r)n-1

 

Where,

 

P is the loan amount

 

A is the amount to be paid

 

r is interest rate and,

 

n is the time period

 

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Journal Entry of Amortization

 

In order to get the tax benefits and deductions everything should be journalized. All the relevant journal entries about the expense amortized should be written in the books of account. 

 

Given below is how you will find out the amount to be recorded while writing the journal entry.

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Recording Amortization Entry

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1. Find the Initial Value of the Asset

 

In case of intangible assets it can be a little difficult to find the initial cost. You may need an accountant’s help to find the initial purchase cost.

 

 

2. Find the Lifespan of the Asset

 

Lifespan is how long the asset will last. How long will you put the asset to use? You need to sort it out. For example- Different assets have different values. Like a patent has different lifespans depending upon type.

 

A design patent is for 14 years from the date you get the rights. So, you will have to amortize a design patent for 14 years.

 

 

3. Find the Residual Value of the Asset

 

Residual value is the balance value or written down value of assets left after use. Once you are done using the asset, you need to find its residual value or remaining value. 

 

When you put an asset to use, its value declines. Moreover, some assets can become complete waste or scrap after use with nil residual value.

 

These three things need to be decided before finding the expense. When you have the value of all of the above three, you can use the formula given below to find the expense that should be amortized.

 

(Initial Value-Residual Value)/ Life of asset
 

Sometimes the residual value is 0 or Nil, in that case you divide the initial value with the life of the asset. The amount is recorded in the Income Statement under the head- Depreciation & Amortization. What is the structure of journal entry? You need to Debit the amortized expense and Credit the asset. 

 

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How is Amortization different from Depreciation?

 

Often people get confused in both these terms. By now you must have got an idea about the concept of Amortization. It is time to differentiate both these terms to get a clearer picture of it. 

 

The points given below explain the key differences between Amortization and Depreciation.

 

1. The basic difference lies in the fact that Amortization is for intangible assets like patents, copyrights and trademarks. 

 

Whereas Depreciation is for tangible assets like Plant & Machinery etc.

 

2. Amortization is always done by following the SLM approach so that equal amount is written off every every from the cost of the asset. 

 

Depreciation is done using Straight Line Method (SLM) and Written Down Value (WDV) methods because it is a common practice to recognize it in earlier reporting periods i.e. at an accelerated pace.

 

3. Salvage value of an asset is another point of difference between the two. In case of intangible assets usually there is no salvage or resale value. Therefore, while calculating amortization expenses we do not take resale value in the formula. 

 

Whereas tangible assets can be resold and have salvage value. Therefore, we include salvage value in the formula while calculating depreciation.

 

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Amortization reflects the gradual decline in the value of an intangible asset. It slowly changes the position of an asset from the balance sheet into the income statement by charging the expenses.