A company can calculate its losses and include them on its balance sheet as expenses when it owns an asset that depreciates or loses value over time. The asset eventually reaches a “salvage value,” or an estimated value, when depreciation is complete at the end of its estimated useful life.
Three types of assets experience either depreciation or amortization: physical property (which includes everything from buildings to machinery and technology), natural resources such as oil wells and intangible assets.
What Is Amortization?
"Amortization" specifically refers to the loss in value of intangible assets over time. You can calculate an amortization schedule in a few ways. The straight-line method – similar to the “straight line depreciation” method for tangible assets – is one commonly used amortization method for intangible assets.
Accountants calculate amortization as a means of spreading the cost of an intangible asset across all the years of its profitable life span and determining the value it's lost.
What's an Intangible Asset?
Anything without physical substance can be an intangible asset if it generates capital for a business or organization. Intangible assets include intellectual property such as copyrights, patents, trade names, franchise rights, government licenses and goodwill. They lose value from their asset cost or purchase price as they expire or otherwise fail to produce dependable streams of revenue.
How Does Amortization Affect Companies?
According to the Corporate Finance Institute (CFI), a company is typically required to amortize its intangible assets that have a definite life. However, when the asset has an indefinite life, it's a choice, and it can be a tricky one. The useful life of some types of assets can be difficult to identify.
The expenses of maintaining them must be recognized and identified. Their value must be systematically reduced per accounting period. This obviously impacts the company's bottom line, financial statements and income statements.
The final decision as to whether to amortize or not amortize is often made by the company's independent auditors. In addition, note that assets with indefinite lives will still need to be checked for impairment even if they don't get amortized.
Straight-Line Amortization of Bonds
The straight-line method of amortization applies to a bond’s life in the investment industry. A bond is essentially a loan made to a company. Corporations sell bonds to raise money from individual small investors who buy them. A company might issue a hundred $1,000 bonds if it needs to raise $100,000.
All bonds come with maturity periods. A bond's book value must equal its original value when it reaches maturity. The company must pay off all positive or negative interest expenses on the bond at this time. The money that's paid to ensure that a bond equals its book value when it reaches maturity constitutes amortized funds.
Straight-Line Amortization Formula for Bonds
The straight-line amortization formula that's applied to bonds requires just basic math. The formula goes like this:
Amortization/Interest Payments = (Bond Amount with Interest - Original Bond Amount) / Number of Periods.
Assume that a $1,000 bond carries an actual value of $1,475. It has a maturity period of five years. An accountant calculates amortization payments annually. The equation would work out like this:
Amortization/Interest Payments = (1,475 – 1,000) / 5; or, 475/5 = 95.
This company must pay $95 in amortization annually on the bond.
Bonds can lose value in some cases, and a company must then pay the bond back up to its initial price. A bond issued at $1,000 might carry an actual value of $935. Amortization payments ensure that the bond realizes its initial worth upon maturity in these cases.
The Straight-Line Formula on a Balance Sheet
Universal CPA Review indicates that the journal entry would be a simple matter of debiting the amortization expense, then crediting the accumulated amortization. The value of an asset on a balance sheet is reduced by the amortization expense that's been charged. The process goes on until the asset is retired or sold or reaches its salvage value.
The cost or purchase price of an asset would be divided by its useful life. A company could deduct $1,000 from its taxable income each year for five years if it used straight-line amortization to depreciate a $5,000 asset.
Straight-Line Amortization in Identical Payments
The straight-line method of amortization gets its name from the uniform payments it creates in lending situations.
Using this formula allows accountants to develop a “straight line” of identical payments in equal amounts that are due at measured intervals over a predetermined period of time. Although straight-line amortization applies to bonds in the investment industry, the method can technically address any situation in which a person or a company must make uniform payments over a set number of years or a period of time.
Mortgage payments, which are equal periodic payments toward a loan that include both principal and interest applied at the contracted interest rate, are an example of amortization in real estate. Payments made early in the loan's life are made up of a greater amount of interest than principal. This reverses as the principal balance is gradually paid down, at which time the principal repayments grow.
Payment amounts can be calculated using the straight-line amortization method if you know the total value of the loan, including the interest rate and its length, according to CFI. Mortgage repayment constitutes amortization because the lender eventually loses its claim to the loans when borrowers pay them off and take ownership and it thus loses an intangible financial asset.
This article was written by PocketSense staff. If you have any questions, please reach out to us on our contact us page.