Amortisation calculation example
Here is an example of how to calculate amortisation:
Let us say a company purchases an asset for Rs. 100,000 with a useful life of 10 years. The company can use the straight-line method to calculate the amortisation expense each year. The formula for straight-line amortisation is:
Amortisation expense = (Cost of asset - Salvage value) / Useful life
In this case, the calculation would be:
Amortisation expense = (Rs. 100,000 - Rs. 0) / 10
Amortisation expense = Rs. 10,000 per year
So, the company would record an amortisation expense of Rs. 10,000 each year for 10 years.
Types of Amortization
Here are some common types of amortization:
- Straight-line amortization: With this method, the borrower makes equal payments over the loan term. Each payment comprises both interest and principal components. As the loan balance decreases, the interest portion of the payment also reduces.
- Balloon payment amortization: In this approach, smaller payments are made over the loan term, followed by a significant "balloon" payment at the end. This strategy can lower initial monthly payments, making it suitable for mortgages and other long-term loans.
- Negative amortization: Negative amortization occurs when the loan payments are insufficient to cover the interest accrued. The unpaid interest is added to the principal balance, causing the loan to grow over time.
- Interest-only amortization: With this method, the borrower pays only the interest on the loan for a specified period. The principal amount is repaid in a lump sum at the end of the term. This can be beneficial for borrowers who anticipate increased income in the future.
Accelerated amortization: Accelerated amortization involves making larger-than-required payments to reduce the loan term and total interest paid. This strategy can save money on interest costs over the life of the loan.
What is depreciation?
Depreciation serves as an accounting method used to spread out the cost of tangible assets over their useful lifespan. This gradual expense recognition method allows businesses to match the use of assets with the revenue they generate, promoting financial accuracy. Depreciation involves deducting an asset's cost over its useful life, with assets categorised into different classes, each with its specific lifespan. These assets are known as depreciable assets.
Various depreciation methods, like straight-line or accelerated, can be employed, depending on the asset and financial strategy. Accumulated depreciation signifies the total depreciation recorded on an asset up to a particular date. The carrying value on the balance sheet is the asset's historical cost minus accumulated depreciation, reflecting its remaining value. This residual value is termed the salvage value.
Depreciation calculation example
Let us say a company purchases a machine for Rs. 10,000 with a useful life of 5 years and no salvage value. The company can use the straight-line method to calculate the depreciation expense each year. The formula for straight-line depreciation is:
Depreciation expense = (Cost of asset - Salvage value) / Useful life
In this case, the calculation would be:
Depreciation expense = (Rs. 10,000 - Rs. 0) / 5
Depreciation expense = Rs. 2,000 per year
So, the company would record a depreciation expense of Rs. 2,000 each year for 5 years.
Types of Depreciation
Here are some common depreciation methods:
- Straight-line depreciation: This method allocates equal depreciation expense to each period of the asset's useful life. It's a simple approach that considers the asset's lifespan and its decline in value over time. Declining balance depreciation: This method allocates higher depreciation expense in the early years of the asset's life and lower expense in later years. This reflects the idea that assets often lose value more rapidly in their early years of use.
- Declining balance depreciation: This method allocates higher depreciation expense in the early years of the asset's life and lower expense in later years. This reflects the idea that assets often lose value more rapidly in their early years of use.
- Annual depreciation: This method involves reducing the asset's value by a fixed amount each year, gradually decreasing its book value over time.
- Units of production depreciation: This method allocates depreciation expense based on the number of units the asset produces. It's suitable for assets whose value declines with usage rather than with the passage of time. Accelerated depreciation: Accelerated depreciation methods, such as the double declining balance method, allocate higher depreciation expense in the early years of the asset's life. This can result in significant tax benefits in the early years, as it reduces taxable income.
- Accelerated depreciation: Accelerated depreciation methods, such as the double declining balance method, allocate higher depreciation expense in the early years of the asset's life. This can result in significant tax benefits in the early years, as it reduces taxable income.
- Double declining balance depreciation: This is an accelerated depreciation method that doubles the straight-line depreciation rate. It's particularly useful for assets that rapidly lose value in their early years, such as technology equipment.
Amortisation vs. depreciation: Key differences
Key differences between amortization and depreciation are-
Amortization
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Depreciation
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Used to expense intangible assets over their useful life
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Used to expense tangible assets over their useful life
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Straight-line method is often the only method used
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Many different methods are used
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Assets expensed using this method typically do not have any resale or salvage value
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Assets expensed using this method typically have some salvage value
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Examples of intangible assets that are expensed through amortisation include patents, trademarks, franchise agreements, copyrights, costs of issuing bonds to raise capital, or organisational costs
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Examples of tangible assets that are expensed through depreciation include buildings, equipment, machinery, and vehicles
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The expense amounts are then used as a tax deduction, reducing the tax liability of the business
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The expense amounts are then used as a tax deduction, reducing the tax liability of the business
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Amortisation is shown on the income statement as an expense
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Depreciation is shown on the income statement as an expense
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Amortisation is shown on the balance sheet as a contra-asset account
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Depreciation is shown on the balance sheet as accumulated depreciation
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Conclusion
Understanding the distinctions between amortisation and depreciation is vital for accurate financial reporting and tax planning. Both methods serve the purpose of allocating the cost of assets over their useful life, but they are applied to different types of assets—intangible and tangible, respectively.
It is crucial for businesses and individuals alike to grasp these accounting practices to make informed decisions regarding their assets, investments, and financial strategies.
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