Definition of Amortization – Hello Sinaumedia friends, some of you may have heard or often heard the term amortization. This term is commonly used in the business world, especially in finance and accounting. Basically the concept of amortization is an accounting process that plays an important role in knowing the condition and financial statements of a business.
Simply put, amortization is taken to reduce the cost and value of intangible assets. This activity is carried out periodically because it is related to the devaluation or impairment of the value and economic life of the company’s assets.
Based on this interpretation, we can conclude that the concept of amortization is different from depreciation or depreciation. Therefore, amortization cannot be equated with depreciation, even though the two have interdependent roles.
But, what exactly is meant by the notion of amortization? So, in this article, we will discuss more about the meaning of amortization. Regarding this, continue reading this article so you don’t misunderstand the meaning of amortization.
Definition of Amortization
Amortization comes from the English word, which comes from the word amortize . Literally, the meaning of the word amortize is “to bring death”. Later, this term was used in the fields of finance, accounting, and taxation. Thus, the definition of amortization is a debt settlement procedure that takes place in stages over a certain period of time.
The definition of amortization is a repayment process that takes place over a certain period of time or period and also occurs in stages. A simple example of this amortization payment is paying monthly bills for car loans, credit card loans, mortgage loans, and many, many more.
Amortization payment procedure also has its own method of calculation. But what is certain is that the number of installments or the number of installments must be greater than the principal amount of the loan and the interest that must be issued by the borrower.
Thus, this amortization value will be amortized in stages according to each installment. Amortization can also be understood as the spread of the amount or cost of capital as an asset or intangible asset over a certain period of time. Usually, amortization is applied over the life of the asset.
Another interpretation of the concept of amortization is an accounting process that is carried out by gradually reducing the value of liabilities or expenses and intangible assets. The write-off of intangible assets will be carried out in accordance with their economic life, limited by making allowances for periodic expenses on the value of income.
The cost allocation for these intangible assets will focus more on reducing the value of liabilities. This is done by the procedure for paying the principal of the loan at the same time as the interest. So that later you will know the amount of installments that must be paid until the loan period can be repaid.
Another function of depreciation is to reflect the resale value of intangible assets. An example is when you take out a loan with a certain installment price, you will find that the amortization value is the same as the number of installments that must be paid.
However, to understand the meaning of depreciation, we must also understand the term amortization fund. What is meant by amortization fund is an attempt to collect funds or cash periodically so that the amortization fee for each period can be paid off. As a result, the company will be able to pay bills from its current amortization expense.
In addition to the definition above, according to the Financial Services Authority (OJK), amortization is an accounting procedure that systematically reduces the value of costs and fixed assets or other intangible assets through recurring expenses on profit and loss. Depreciation amortization applies to intangible assets that have an identifiable useful life.
The useful life is the economic life of the asset (the length of time the asset is useful to the owner) or the contractual/legal age (eg the life of a patent or license). Limiting factors such as government regulations or other market factors can cause the economic life of an asset to be shorter than its legal or contractual life.
In the accounting books, the company’s intangible assets are presented in the long-term assets section of the balance sheet, while amortized expenses are recognized in the income statement. However, because amortization is a non-cash expense, it is not reflected in a company’s statement of cash flows or in certain measures of profit, such as earnings before interest, taxes, depreciation and amortization (EBITDA).
Amortization of intangible assets is important because it can reduce taxable income and tax liabilities and help investors better understand their true operating income.
In business, if a business is amortizing costs, amortization can help relate the cost of an asset to the revenue it generates. For example, if your company buys a dozen fabrics, it will list costs in the year of purchase and will typically use all of the fabrics that same year.
On the other hand, with large assets (purchasing large quantities of cloth), the company will benefit in terms of costs for several years. This can reduce costs gradually over several years.
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Thus, it can be concluded that amortization can be taken to reflect or reflect the resale value of an asset. Thus, the selling price can be known and the company can benefit from amortization.
Relation between Amortization and Depreciation
As previously explained, amortization has a relationship with asset depreciation. In addition to the understanding relationship, these two terms in the world of accounting also have a relationship on a number of other issues.
As understood, both depreciation and amortization are related to changes in asset values. Thus, the concept of amortization is the decline in the value of intangible assets, while depreciation is the change in the value of tangible assets.
Both also have related functions. While the amortization function reflects the value of a business’s assets when they are resold, the depreciation function is so that the business can receive and maintain income for a given month in the value of an asset. Thus, depreciation and amortization both work by changing the value of a company’s assets over the long term.
Amortization and depreciation are also related to its performance. Both are usually taken by the company during the month of issuance. That is, amortization and depreciation are inseparable. For this reason, it is not surprising that many people think these two words have the same meaning, and many are confused about the difference between the two.
The difference between Amortization and Depreciation
As mentioned in the previous section, even though amortization and depreciation are related, they still have differences. In general, asset depreciation is the cost of depreciating fixed assets for their benefits, such as motorized vehicles.
Meanwhile, amortization is vulnerable to depreciation of intangible assets such as the accounting period. Companies can allocate intangible assets using an allocation system known as Goodwill.
Another difference between depreciation and amortization is that amortization is almost always taken on a straight-line basis, so the depreciation expense recognized in each accounting period is the same. Conversely, depreciation expense is usually recorded on the books under the accelerated method, so that a larger expense is recognized in the earlier accounting period
In the event that there is no residual value in the amortization, this relates to the characteristics of intangible fixed assets which are considered to have no resale value at the end of their useful life or economic life. In fact, tangible assets in depreciation always have a residual value or residual value from the use of these assets so that they can be included in the depreciation calculation.
Amortization Example
Companies often write off certain intangible assets for amortization, such as goodwill . There is also usually an allocation of whatever value is paid when buying preferences or bonds. Meanwhile, in an amortization fund , this amortization fund can be collected periodically to cover amortization costs.
Example 1
An example of amortization is a company that has a loan of Rp. 10,000,000 and is paid in installments of Rp. 200,000 per year, from this the company has amortized a loan of Rp. 200,000 per year.
Example 2
Depreciation will certainly be easier to understand if it is accompanied by a case study. The simplest case study is when a company has a loan of Rp. 10 million and need to make annual payments of IDR 750,000. Based on this case study, it is conceivable that the company has amortized loans of up to Rp. 750,000 per year.
Example 3
Another case study is when a garment company holds a patent on a machine for a period of 10 years. When the company spends Rp. 250 million to develop their product, the cost of amortization is 25 million because it must be divided by the cost of the useful mass of the machine.
How to Calculate Amortization
Amortization activities will oblige business actors to be able to pay off debts, including repaying the principal or principal of the loan and paying interest. The purpose of the principal loan in this case is the debt balance that must be outstanding and must also be repaid by the company.
Interest payments will decrease if the principal amount to be paid increases. Over time, the amount of interest that must be paid later can decrease, but the amount of principal payments can increase.
Ways that can be done to calculate amortization, namely:
Calculating Loan Amortization in the First Month
There are six steps a company must take to be able to calculate interest and principal during the first month of amortization. The first step is to collect data so that the first amortization can be calculated. Some of the information you need is interest rates, loan terms, and loan principal.
The second step is to prepare working papers so that the calculation process runs smoothly. In this case, you only need Microsoft Excel to calculate the amortization. Fill in the table by month, principal payments, interest payments, installment amounts, and loan balances.
Then the next step is to determine the loan for the previous month and also calculate the installment amount. The formula that can be used to calculate the amount of installments is
Installment Amount = P x (i / 12) / 1 – (1+ (i / 12) -t), where P is the principal, i is the interest rate and t is the tenor of the loan or the term of the loan.
A simple example is if company ABC has a principal loan of 10 million rupiah, with an interest rate of 6% and a tenor of 12 months. Then the calculation of the installment amount is 1 0,000,000 x (6% / 12) / 1 – (1+ (6% / 12) -12) = 860,664.
If you already know the installment amount, the next step is to calculate the installment interest. The formula for calculating interest installments is the previous month’s principal minus the interest rate multiplied by 30/36 0. Applying the formula from the previous example, we will see that the interest payment for the first month is 10,000,000 x 6% x (30/360) = 50,000 .
The fifth step that must be taken if you already know the value of the installment amount and the amount of interest is to find out information regarding the principal installments that must be paid. It’s easier, you can find out the principal installments by reducing the number of installments along with the interest. Based on the previous example, we can see that the principal installment is 860,664 -50,000 = 810,664.
The sixth step that needs to be done is to calculate the loan balance by subtracting the previous month’s principal amount from the principal payment amount. Based on the example above, we can see that the loan balance is 1 0,000,000 – 810,664 = 9,189,336.
So, by using the six steps above, we can get an idea of the allocation of debt balances owned by the company.
Calculating Loan Amortization for the Entire Loan
To calculate loan amortization over the life of the loan, businesses can use the spreadsheet or worksheet that was created in step two. The following is the result of calculating the 12-month amortization based on the example above:
By using the information on the worksheet, one can see whether the value of the principal payment each month will increase or whether the value of the interest installment payment will decrease. However, it is also possible to find out if the balance or principal of each installment payment always decreases until it is finally paid off.
Straight Line Method
In accounting, the amortization method is a measure of impairment of an intangible asset. The method of calculation is similar to the depreciation or depreciation of tangible assets, such as machinery and factory buildings.
When a company allocates an intangible asset over a period, the cost of that asset can be related to the revenue generated in each accounting period and deducted from the cost over the useful life of the property.
For accounting purposes, companies usually calculate amortization using the straight-line method. With this method, the cost of an intangible asset is spread evenly over all accounting periods in which the asset can benefit. The formula:
Annual amortization expense = acquisition cost of the asset/useful life
The acquisition cost of the asset takes into account the carrying amount, if any, including other costs incurred to acquire the asset. For example, commissions, legal, administrative and other costs. The useful life here is given as an approximation if there is no definite expiration as required by the country or law.
Example: PT Sinar Jaya buys a computer software copyright from an investor to support the company’s production for IDR 180,000,000. PT Sinar Jaya spends IDR 20,000,000 for patent registration and gets the inventor’s rights for 20 years.
But then there were lawsuits from other inventors over software invention patents. The court process cost PT Sinar Jaya Rp 50,000,000 but won the case. Then the annual amortization fee is:
(IDR 180,000,000 + IDR 20,000,000 + IDR 50,000,000)/20 years = IDR 12,500,000 per year
Declining Balance Method
The declining balance method is a cost and expense allocation system in which the budgeted amount decreases each year as the useful life of the asset increases. With this declining balance method, the depreciation expense will be much higher in the previous year and even lower in the following year.
Amortization Benefits
Amortization is one of the most important aspects of business accounting not just for nothing.
For example, calculating amortization is a surefire way for companies to predict the health of their financial statements. In addition, he can also notify the company about the debts that the company has. So, besides these two things, here are other amortization benefits that companies can get, as disclosed by Chron :
- The clear payment amount includes interest and principal
- A more structured debt and interest payment schedule
- Tax deductions for the current tax year
- Clearer and more structured financial reports
- Reducing the risk of accumulated business debt
Closing
Thus a brief explanation of the meaning of amortization. Calculating amortization should require good accounting and finance skills. In addition to business growth, the advantage of calculating amortization is that it can be used as a tax deduction basis.
In this case, the company must refer to government regulations regarding tax amortization. Generally, the government regulates tax amortization through the Ministry of Finance. To simplify bookkeeping, entrepreneurs can use accounting software that can simplify processes and reduce the risk of calculation errors.
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