Amortization

What is amortization?

Amortization is the accounting concept that refers to the loss of value of an asset for a period of time of useful life.

Amortization is recorded with the intention of reflecting the real value of a property, since it is affected by the use or wear throughout its duration or useful life, and its calculation generally takes into account the residual value.

Within this concept, useful life is understood as the time during which the good is expected to be usable. It is also understood by residual value the value that is estimated to be recovered from an asset when its estimated useful life has elapsed and that it is fully amortized, in other words, the value of the good that the company would obtain from selling it when it has completed its useful life.

For example: An industrial machine is purchased for $ 10,000 and is estimated to last 20 years, in turn, its residual value will be $ 300. In conclusion, its annual amortization will be the result of dividing its value ($ 10,000) minus the residual value ($ 300) by its useful life (20 years). That is, its amortization is $ 485 per year.

How is amortization calculated?

Although there are several methods to calculate amortization according to the level of complexity, we will see the simplest and most used method due to its easy application to all types of goods, it is the straight-line depreciation method.

In this method, a depreciation value is amortized or recorded annually, which is the same for all periods and is therefore called straight-line.

To calculate it, the value of the property is taken, the residual value is subtracted and then divided by the years of estimated useful life.

Formula to calculate amortization.

For this formula, you need to take into account:

• Initial value of the good: original price for which the good was acquired.
• Residual value: it is the value of the good that the company would obtain by selling it when it has completed its useful life.
• Estimated useful life: approximate duration of the asset expressed in years.

Amortization, depreciation and depletion

The term amortization can be confused with depreciation and depletion because these three concepts are used to reflect the real value of goods, but its application is different as shown below:

• Amortization Y depreciation They are concepts that share similarities, both are generally applicable to assets that suffer wear or loss of value, such as buildings, vehicles, machinery. Sometimes, it tends to differ in applying amortization to intangible assets and depreciation to tangible assets.
• As to exhaustion, this concept is applicable to the reduction of natural resources such as oil wells, wood forests

Examples of amortizations

Example 1

A company amortization for its management strategies, which requires the projection of the amortization of a property that has a initial value of $ 5,400 with a useful life 5 years old, a residual value of $ 400.

Taking into account the amortization formula through the straight-line method, it is calculated:

It is then understood that the annual amortization value is $ 1,000. This will allow the company to know if the production will be able to cover the amortization of the good in order to obtain benefits.

Example # 2

A company acquires a technological patent at a value of $ 100,000 for 15 years, however, due to technological advances, it is estimated that this patent will last 7 years. At the end of its useful life, the company will not be able to obtain anything from selling it, so its residual value is 0.

Taking into account the amortization formula through the straight-line method, it is calculated:

Therefore, the amount to be amortized annually will be $ 14,285.71.