Running a small business means you are no stranger to the financial juggling of your expenses, assets, and cash flow. There are many instances where companies will need to take out a loan or pay off assets over multiple accounting periods. Using amortization in such cases can be a beneficial accounting method for the business.
Why should your company utilize amortization, and how does this accounting technique pay off in the long run?
What is Amortization in Simple Terms?
Amortization is an accounting term used to describe the act of spreading the cost of a loan or intangible asset over a specified period with incremental monthly payments. This accounting function is to help companies cover their operating costs over time, while still being able to utilize and make money off of what they are paying off.
There are typically two types of amortization in accounting- for loans and intangible assets.
Assets refer to something that creates earnings or brings value to a person or company. Tangible assets refer to things that are physically real or perceptible to touch. Equipment, vehicles, office space, and inventory are all common tangible assets of a company.
An intangible asset refers to things that cannot be physically touched but are real nonetheless.
Therefore, such business assets could be:
- Government licenses
- Rights to a film
Loan amortization is paying off the debt of something over a specified period. A business that uses this option is building equity in the loaned asset while paying off the item at the same time. At the end of the amortized period, the borrower will own the asset outright.
Depreciation vs. Amortization
Depreciation and the amortization of assets are similar accounting concepts. However, depreciation refers to spreading the cost of a fixed asset out over time. In contrast, amortization is the spreading of costs associated with the life of an intangible asset. The recording of these two types of payments within your financial documents will differ.
To accurately record the periodic payment of an intangible asset, two entries are made in the company’s books. First, a debit to the amortization expense is entered, then a corresponding credit to the intangible asset account is entered. Depreciation, on the other hand, would have a credit placed in the contra asset accumulated depreciation.
What is an Example of Amortization?
An example of an amortized intangible asset could be the licensing for machinery or a patent for your business. Suppose a business makes a specific car part for high-end vehicles. The creation of this car part uses schematics that are patented. Therefore, the company’s intangible asset is this schematic patent.
If the patent runs for 30 years, the company must calculate the total value of the intangible to the company and spread its monthly payment over this asset’s life. This accounting function allows the company to use and capitalize on the patent while paying off its life value over time.
Scheduling Period Payments
If a company is going to amortize something, it will have an attached amortization schedule. This schedule is a table detailing the periodic payments of said loan or asset. These regular installments are generated using an amortization calculator. The allocation of costs over a specified period must be paid in full by the time of the maturity date or deadline.
How do you Calculate Amortization?
There are easy to use schedule calculators that can help you figure out the best loan repayments schedule, taking into account the interest rates and loan type and terms.
One of the trickiest parts of using this accounting technique for a business’s assets is the estimation of the intangible’s service life. Business operators must weigh out the economic value to the company, including the book value, residual value, and the useful life of the intangible asset.
Many intangibles have a specific legal life attached to them. However, the service life could be considerably shorter than the legal life of an intangible asset. Generally, the amortization of these assets must be at least 15 years.
The straight-line method is the equal dispersion of monetary instalments over each accounting period. Generally, this method is the go-to scheduling of payments for businesses. It allows for steady expenses throughout the allocated time.
The expense is calculated as the amortization cost divided by the intangible asset’s estimated useful life, using equally allocated payments. The formula is as follows:
Amortization = (Book Value – Residual Value) / Useful Life
The accelerated method is the process of payment of the asset whereby the allocation of costs is higher in the earlier years of use, and lower later on.
The units-of-production-period method measures out payment amounts that reflect the actual use of the non-physical asset within that period.
Is This Accounting Technique Good or Bad?
There are many reasons why people choose to use this accounting practice. Amortization is neither good nor bad, but there are certain benefits and downsides to its utilization.
Using this technique to spread your business’s payments of intangible assets or loans over time will reduce taxes for your business for the current tax year. For however long you are using that asset, you are entitled to a deduction on your taxes.
Thus, you could gain a tax break for the entirety of the loan period, benefitting your business for numerous accounting periods. Furthermore, amortization enables your business to possess more income and assets on the balance sheet.
However, for some, these loan payments happen over a long period, meaning it’s a very slow and drawn-out process. Depending on the payment method used, some payment periods can be quite high, causing cash flow issues within the business.
How Amortization Applies to Your Small Business
Even though intangible assets cannot be touched, they are still an essential aspect of operating many businesses. Amortization is the affirmation that such assets hold value in a company and must be monitored and accounted for.
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