Last Updated on May 24, 2022 by Anjali Chourasiya
In the world of finance, amortisation is used regularly for various accounting purposes. Amortisation is an accounting technique largely used to record and ascertain the value of an intangible asset/loan over a set period. In organisations, this method is used to plan principal and interest payments against secured and unsecured debt at regular instalments. Novices tend to confuse amortisation with depreciation. But, there are stark differences between the two. Let us understand amortisation in detail.
Table of Contents
What is amortisation?
The term amortisation is largely used to assist the value of a loan or intangible assets. Just like tangible assets, intangible assets also experience wear and tear, i.e., they depreciate and lose value over time. Their life shell is measured through contact expiry and other such factors. Every company needs to assign value to these intangible assets. This process is referred to as amortisation.
Amortisation can also be referred to as the process of paying off a debt through principal and interest over time. In simple terms, to amortise any asset implies reducing its value over time. This is to write off the asset’s cost over a period of time. This reduction is to be accounted for in the balance sheet.
Both depreciation and amortisation are treated as non-cash expenses, i.e., there are no cash reductions when they are recorded.
Lenders, such as financial institutions, typically use amortisation schedules to offer a loan repayment schedule based on the maturity date. Companies use various methods and tools to calculate amortisation.
Amortisation calculation
Assume you wish to calculate amortisation for copyright purchased at Rs. 1,00,000 with its useful life valued at 10 yrs. Then, the amortisation will be calculated as follows:
Purchase price/ Considered shell life = Amortisation per yr
1,00,000/10 = 10,000
Here, you would report amortisation for the copyright in your accounts as Rs. 10,000.
This is the generally used formula for calculating amortisation. But companies that deal with loans and their accounting follow a more mathematical formula, which is as below:
A = P x r(1+r)^n/ (1+r)^n – 1
Here: A = amount payable
P = Principle
r = rate of interest
n = Installment period
Difference between amortisation and depreciation
The concepts of amortisation and depreciation are similar as both attempt to capture the cost of holding an asset over time. However, the main difference is that amortisation is used largely in reference to intangible assets like patents and trademarks, among others. In contrast, depreciation is applicable to tangible assets like equipment, buildings, vehicles, and other assets subject to physical wear and tear.
Also, amortized assets do not have a salvage value because they are intangible. Salvage value is the estimated resale value of an asset at the end of its useful life. Depreciated assets, on the other hand, often have a salvage value. This value is generally subtracted from the asset cost to determine the amount by which it can be depreciated.
Types of amortisation
As a process, the amortisation of debts and dues can be structured in a variety of ways. They are:
Fixed-rate amortization
In this method, the borrower pays a fixed sum of money periodically that includes both the principal as well as the interest repayment component, for the whole term of the loan. This method utilizes a fixed interest rate throughout the lifetime of the loan.
Variable-rate amortization
Many loans are amortized at a variable interest rate for a proportion of the loan period. For example, a 25 yrs loan period may start off with a 5-yr term with a fixed interest rate and later a fluctuating interest rate (for the remainder of the term). Essentially, every time the interest rate changes, a new amortization schedule is calculated for the rest of the term and payments are attracted accordingly.
Deferred interest amortization
For such loans, the loan amortization schedule is structured in such a way that a majority of the interest due for the loan amount is collected in the initial period of the loan, (for example, first 7 yrs in a 21-yr loan) before collecting interest as well as principal payments. This format is popularly used in residential housing loans.
Negative amortization
In this method, the loan repayment does not cover the entire interest payment, which is why the initial principal interest due keeps growing with time. It is intended to be a loan format that allows flexible repayments, however, this looming outstanding payment can potentially keep growing indefinitely in this method, much like a compounding reverse annuity.
Why is amortisation important?
Amortisation helps businesses understand the cost of capital and plan for these expenses as a part of the monthly, quarterly, or annual cash flow. It provides clarity on interest vs principal repayment over the course of the loan. This distinction is vital for tax computation and planning.
It also assists business owners in regular accounting and book-keeping by enabling asset-owners to assess yield rates and future income on their assets. Lastly, it helps for systematic and linear accounting of every asset, whether tangible or intangible, giving the owner/payee absolute value of his asset or purchase
All assets are accounted for differently. For intangible assets, this process can get tricker. Amortisation is fundamentally used for writing off the value of these intangible assets and loans over a period of time. It is extremely important to understand the intrinsic meaning of amortisation as it is widely used for accounting and taxation purposes. It is not the same as depreciation and is used separately to ascertain the value of assets, purchases and even the profits that large organizations earn after taxes.
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