What is amortization? Definition, calculation and example

0

The amortization of the value of an intangible asset can be spread over years or months.

What is amortization?

Amortization is the reduction in value of a property or the repayment of a loan over a period of time. From a business perspective, it would be amortization of expenditure on assets, especially intangible assets such as intellectual property rights. From a banker’s point of view, it means extending the repayment period of a loan to give the borrower the opportunity to repay a fixed amount.

In accounting parlance, depreciation is the process of allocating the costs of durable assets, or “long-lived assets”, over a period during which these assets are expected to provide economic benefits. This article mainly focuses on how companies deal with the amortization of intangible assets.

Depreciation tends to be associated with depreciation, which focuses on physical assets such as plant, machinery, and equipment. (Some accountants and analysts tend to omit property on the assumption that property does not depreciate.) A business amortizes intangible assets such as copyrights, patents, trademarks, software, licenses or other forms of intellectual property rights due to obsolescence or adaptation of new technologies. A 5-year patent is about to expire and the company must note the value of the remaining years of the rights. A copyright acquired in an acquisition is soon to end, and the company wants to amortize that.

Large companies that have many subsidiaries and have been in operation for a long time usually have intangible assets that can be amortized. At the same time, start-up companies also write off expenses on assets related to the cost of establishing their business.

How is depreciation calculated?

Exactly how depreciation is calculated depends on what is specifically written. Here it is broken down between intangible assets and loans.

Asset Depreciation Calculation

Calculating depreciation requires estimating the useful life of an asset. When a company acquires a competitor and its patents, it can immediately amortize what it believes to be the life of the patents over a period of time. If the company wants to amortize a patent but cannot determine the lifespan, it will use the straight-line method, which means reducing the value of the asset at a constant rate over a period of time until the final value is zero.

According to the linear method:

Depreciation expense = (Cost - Residual value) / Useful life in periods

Depreciation expense = (Cost – Residual value) / Useful life in periods

In one example, a patent valued at $10 million is amortized over 5 years with no residual value, which means that the value of the patent at the end of the 5th year will be zero. Using the straight-line formula, ($10,000,000 – $0) / 5 = $2,000,000, $2 million is the depreciation expense per year.

The table below highlights this linear method:

Patent year Starting value Depreciation expense Accumulated depreciation Final value

1

$10,000,000

$2,000,000

$2,000,000

$8,000,000

2

$8,000,000

$2,000,000

$4,000,000

$6,000,000

3

$6,000,000

$2,000,000

$6,000,000

$4,000,000

4

$4,000,000

$2,000,000

$8,000,000

$2,000,000

5

$2,000,000

$2,000,000

$10,000,000

$0

TheStreet Dictionary Terms

On the accounting entries, the amortization of the patent would appear as follows, by period:

Debit Credit

Depreciation expense

$2,000,000

Accumulated depreciation

$2,000,000

Loan amortization calculation

There are two common methods of loan amortization: straight-line amortization, as mentioned above with assets, and mortgage amortization. Either method can be used on different types of loans: home equity, auto, and personal.

Amortization of loans = (Principal + Interest) / Number of periods

Amortization of loans = (Principal + Interest) / Number of periods

In the table below, using the straight-line method, a $10,000 loan bears 6% annual interest and a fixed payment of $500 per month. As the balance decreases each month, the interest payment also decreases, but the principal payment increases. After calculating the principal and interest payment per month, the loan is likely to be repaid in 22 months.

Month Balance (beginning) Payment Main Interest (6% per year; 0.5% per month) Balance (End)

1

$10,000.00

$500.00

$450.00

$50.00

$9,550.00

2

$9,550.00

$500.00

$452.25

$47.75

$9,097.75

3

$9,097.75

$500.00

$454.51

$45.49

$8,643.24

4

$8,643.24

$500.00

$456.78

$43.22

$8,186.45

5

$8,186.45

$500.00

$459.07

$40.93

$7,727.39

6

$7,727.39

$500.00

$461.36

$38.64

$7,266.02

seven

$7,266.02

$500.00

$463.67

$36.33

$6,802.35

8

$6,802.35

$500.00

$465.99

$34.01

$6,336.37

9

$6,336.37

$500.00

$468.32

$31.68

$5,868.05

ten

$5,868.05

$500.00

$470.66

$29.34

$5,397.39

11

$5,397.39

$500.00

$473.01

$26.99

$4,924.38

12

$4,924.38

$500.00

$475.38

$24.62

$4,449.00

13

$4,449.00

$500.00

$477.76

$22.24

$3,971.24

14

$3,971.24

$500.00

$480.14

$19.86

$3,491.10

15

$3,491.10

$500.00

$482.54

$17.46

$3,008.55

16

$3,008.55

$500.00

$484.96

$15.04

$2,523.60

17

$2,523.60

$500.00

$487.38

$12.62

$2,036.21

18

$2,036.21

$500.00

$489.82

$10.18

$1,546.40

19

$1,546.40

$500.00

$492.27

$7.73

$1,054.13

20

$1,054.13

$500.00

$494.73

$5.27

$559.40

21

$559.40

$500.00

$497.20

$2.80

$62.20

22

$62.20

$500.00

$499.69

$0.31

$0

In a mortgage-style amortization, for that same $10,000 loan with an annual interest rate of 6%, the interest payments will initially be greater than the principal. But the payment of principal and interest tends to be equal in the middle of the duration of the amortization period.

Where is the amortization in the financial statements?

For many companies, depreciation is an expense item that can be found in the income statement of financial statements filed quarterly and annually with the Securities and Exchange Commission. Depreciation tends to be grouped together with amortization as a single item in operating expenses because they focus on the reduction in value of assets during that period of the financial statement. In some cases, depreciation and amortization expense may be small and would be lumped together with selling, general and administrative expenses.

Depreciation, like amortization, is a non-cash expense because the value of the asset is depreciated over a period, but it reduces profits on the income statement. Nevertheless, amortization, as well as depreciation, will appear in the statement of cash flows to highlight the specific costs associated with the impairment of certain assets.

Where is damping used?

Depreciation is used in measures such as EBITDA, which represents earnings before interest, taxes, depreciation and amortization. For EBITDA, depreciation and amortization are among the items added to net income to show investors how a company earns profit primarily on an operating basis.

Frequently Asked Questions (FAQ)

Here are the answers to some of the most frequently asked questions by investors about depreciation.

Are depreciation and depreciation the same?

Both are similar in concept of depreciating assets over time, but depreciation focuses on intangible assets and depreciation revolves around physical assets.

Is goodwill amortized?

Goodwill, which is intangible assets acquired by merger or acquisition not attributable to other income-producing assets, and intangible assets with an indefinite useful life are not amortized.

Is depreciation tax deductible?

Depreciated items may be deducted from tax liabilities due to the depreciation in their value.

Share.

Comments are closed.