Meaning of Amortisation and How to Calculate it?

Businesses require assets and loans to carry out their daily activities. There are two types of assets – tangible and intangible assets that help companies to undertake their daily operations. Amortisation is an accounting technique that allows companies to lower the value of intangible assets and loans in their books of accounts over a set period of time.

Read on to know more about the meaning of amortization and how it works.

Amortisation in finance is a process by which companies gradually write off the book value of their intangible assets and outstanding loans. This process focuses on spreading out or reducing loan payments of a company over time. It allows entities to pay off a debt in regular and pre-determined installments, which include both the interest and principal.

Let's understand amortisation with the help of an example:

Suppose a company starts researching a product module. After years of extensive research, they are able to successfully build that product. In order to secure their rights over the said product, they apply for a patent on it.

The total cost of the patent amounts to ₹200,000, and the patent is valid for 20 years. By using the single-line financing method, the company can amortise the asset by recording ₹10,000 each year as amortisation expenses.

Amortising a loan involves paying the full loan amount as per prefixed recurring instalments. The interest and principal amount for every month will vary from one instalment to other. In the case of loans, the interest component is higher than the principal amount during the initial instalments. As time goes by, the principal component increases, and the interest amount decreases.

Different loans exhibit varied characteristics and depend on the borrowing and lending parties. However, amortising a loan is an efficient way of clearing outstanding debts within a fixed timeline.

Companies also use amortisation to offset the value of intangible assets by spreading the acquisition cost over its useful life cycle. Just as it reduces a loan’s book value, it is used by companies to lower the book value of intangible assets as well.

One can use the straight-line method to amortise intangible assets like trademark, copyright, licenses, etc. The main purpose of amortisation is to equate the cost of acquiring an asset with the profit it will generate during its operation. Now that we have understood what is amortisation let's move on to its other aspects.

Here are some reasons why amortisation is important to businesses and other entities:

• It is critical in a company's functioning as it allows them to efficiently forecast and understand their costs.
• The loan repayment schedule prepared for amortised loans provides greater clarity to lenders and borrowers about the interest and principal components in monthly installments.
• Companies amortise an intangible asset so as to consider that as a deductible expense in the income statement, which reduces their total tax liability.

The different types of loans that can be amortised are as follows:

1. Automobile Loans

Auto loan is a loan taken by a borrower in order to purchase a motor vehicle. These loans are instalment-based loans in which borrowers pay fixed monthly instalments for the entire repayment period, which is usually five years or less than that.

The motor vehicle purchased with this loan is the underlying asset. Borrowers do not have full ownership rights over the motor vehicle till the entire loan is paid off. You can get a direct or indirect loan for financing your automobiles.

Under a direct loan, you secure funding to purchase a motor vehicle directly from a financial institution. They keep the motor vehicle's paper with them till the entire loan gets disposed of. On the other hand, you can also opt for an indirect auto loan through the automobile dealer, where the borrower and dealer enter into a loan contract.

The dealer will sell that contract to a financial institution, and buyers will have to pay off the said loan to a financial institution, just like a direct loan.

2. Home Loans

A home loan is a secured loan in which borrowers keep their home as a mortgage till the loan is paid off. These come with a longer tenure than auto loans. Home loans come at a fixed or floating rate of interest. Borrowers compute their installments after considering the interest and principal components of the loan.

People prefer a fixed interest rate regime in an environment of rising interest rates and floating interest rates when interest rates are constantly fluctuating.

3. Personal Loans

A personal loan is a non-secured loan that comes at a higher interest rate than automobile or home loans. You do not need to provide collateral to get a personal loan from most financial institutions.

These loans are preferred by individuals who have immediate financial requirements. As these loans are unsecured, they come with smaller repayment tenures.

Here are some benefits of amortisation:

• It helps an entity in accurately evaluating the actual benefit that may arise from some specific intangible assets.
• Amortisation also helps borrowers in determining which loan is suitable for them and which financial institution they should approach for getting a loan.
• The amortisation schedule helps borrowers in knowing the loan repayment schedule in advance, and it allows them to plan their finances accordingly.

Amortisation is an efficient accounting tool used by companies to offset the costs of their intangible assets and also pay off their debts in a timely manner. This detailed guide about the meaning of amortisation, its benefits, and working will help our readers gain expert knowledge about how this concept operates.