What is Amortization?
Amortization is a method through which businesses lower the book value of their loans or intangible assets. It is similar to depreciation for assets. Both of these techniques help companies record the gradual decrease in an asset’s book value. However, depreciation only applies to property, plant, and equipment, or fixed assets. In contrast, amortization is only for intangible assets.
For loans, amortization helps companies spread out the book value into various fixed payments. Usually, this process involves using an amortization schedule to record principal and interest payments. In essence, amortization for assets and loans works similarly. However, the accounting treatments for both differ due to the underlying accounts involved.
How does Amortization work?
The matching concept in accounting requires companies to match expenses to the revenues they help generate. Therefore, companies must expense out the relative value of their assets for the period they provide means to make sales. This expense-out process usually comes in the form of depreciation. However, depreciation does not apply to intangible assets. Therefore, companies must use amortization to achieve a similar result.
For loans, amortization follows the same concept. It helps spread out the loan into various fixed payments for each period. Using amortization, companies can split these fixed payments into both interest and principal payment components. However, amortization does not apply to all loans, for example, credit cards or balloon loans.
How to calculate Amortization?
There is no specific formula for amortization. However, companies usually use the straight-line method to calculate amortization for intangible assets. The amortization formula under this method is as follows.
Amortization Expense = Asset’s Cost / Asset’s Useful Life
For loans, the amortization formula is more complex. However, most financial institutions and lenders provide an amortization schedule to borrowers. This schedule includes a calculation of all the interest and principal payments payable on a loan. Companies can use it to spread the loan over the number of total payments.
What are the journal entries for Amortization?
The journal entries for amortization differ based on whether it is for assets or liabilities. For intangible assets, the amortization journal entries are similar to depreciation. The value for the double-entry will depend on the amortization calculation based on the above formula. Nonetheless, the journal entries will be as follows.
Dr Amortization Expense
Cr Accumulated Amortization
For loans, on the other hand, the journal entries will differ. Every time a company makes a repayment, it must record amortization. It must also split the amount into the principal and interest components. As mentioned, this information is readily available from the amortization schedule. Nonetheless, the journal entries for the amortization of loans will be as follows.
Dr Interest Expense
Dr Loan (principal amount)
Cr Cash/Bank
Example
A company, Rage Co., owns software that costs $100,000. The company intends to use it for ten years. Therefore, the company will record an amortization expense for the software each year for its useful life. The annual amortization expense will be $10,000 ($100,000 / 10 years). Therefore, the journal entries will be as follows.
Dr Amortization Expense $10,000
Cr Accumulated Amortization $10,000
On the other hand, the company also obtained a loan from a financial institution. The loan requires Rage Co. to repay $20,000 annually, consisting of both interest and principal components. For the latest payment, the interest component amounts to $15,000. Therefore, the amortization expense journal entries for the loan will be as follows.
Dr Interest Expense $15,000
Dr Loan (principal amount) $5,000
Cr Cash/Bank $20,000
Conclusion
Amortization is a term that refers to the process of decreasing an asset or loan’s book value. For assets, amortization works similarly to depreciation, but for intangible assets only. For loans, on the other hand, amortization spreads the loan payments over time. The accounting treatment for both of these will differ, as discussed above.
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