Amortized cost is the total cost charged through amortization or depreciation. It is the accumulated depreciation, depletion, or amortization of assets owned by a company.
Let us dive in to know what is an amortized cost, where it is used in accounting, and what the advantages or disadvantages of amortized costs.
What is an Amortized Cost?
Amortized cost is the total cost deducted or accumulated for an intangible asset at any given point.
The amortized cost is listed on the balance sheet with a cumulative figure of the total deducted amortization while the yearly deducted amortization cost is present on the income statement.
Amortization refers to the gradual reduction of the total cost of the fixed intangible assets. It is similar to depreciation which is used for tangible assets.
Companies report the accumulated depreciation, amortization, and depletion costs together as a single line item under the fixed assets on the balance sheet.
In simple words, the accumulated depreciation and amortized cost are similar concepts. The only difference is in the categorization of fixed assets.
Another concept of the amortized cost is the total recovered value of a debt instrument at any given point until the maturity date.
When a debt instrument (usually a bond) is amortized, its repayment schedule includes a portion of the principal and interest amount.
The total repaid value of such debt instruments is also called the amortized cost.
How to Calculate the Amortized Cost?
The amortization cost isn’t calculated directly. Rather, it is accumulated over a defined period.
However, the yearly amortization cost is calculated in a few different ways by businesses.
Straight Line Method
The straight-line method requires a salvage value of the intangible asset and an estimate of the useful life.
The formula to calculate straight-line amortization is:
Amortization Cost = (Book Value of the Asset – Estimated Salvage Value) / Useful Life in Years
The yearly amortization is expensed to the income statement while the accumulated cost goes to the balance sheet which is our amortized cost.
Declining Balance Method
The declining balance method uses an amortization rate in percentage of the total book value of the asset. The percentage figure also depends on the useful life of the asset.
Amortization Cost = Total Book Value of the Asset × Amortization Rate
Double-Declining Balance Method
The double-declining method is an accelerated amortization method that uses the double amortization rate.
Amortization Cost = (Total Book Value of the Asset × Amortization Rate) × 2
Accounting rules allow each of these calculation methods. The purpose is to calculate the yearly amortization cost and then add it to the accumulated balance.
Impact of the Amortization Method
The amortization cost is subject to accounting manipulation as accountants have the choice of using one of the several calculation methods discussed above.
The calculations for the amortized cost also depend on estimated figures of the useful life of an intangible asset and its salvage value.
Both these estimates are fairly challenging for intangible assets as compared to tangible assets as the fair market value of intangible assets itself changes frequently.
Therefore, like other depreciation and amortization calculations, the amortized cost calculations are also subjective in nature.
Why Do Businesses Use Amortized Costs?
The amortized cost line item on the balance sheet is a contra-asset account. It is a credit account although it appears on the assets side of the balance sheet.
It simply means that the amortized cost of intangible assets for a business increases each year and the book value of those assets decreases.
The amortized cost has no impact on the fair market value but it does affect the carrying value of an intangible asset.
The purpose of using the amortized cost is to adjust the carrying value of the intangible assets as it is the difference between the historic book value minus the amortized cost of these assets.
If the estimates and the amortization rates are calculated accurately, then the salvage value of the asset would be equal to the historic cost minus the total amortized cost at the end of the useful life of an intangible asset.
The second use of the amortized cost is in debt instruments. Lenders issuing long-term debt instruments use the amortization schedules to recover the principal and the interest charges until the maturity period.
The amortization cost of a debt instrument means the lender receives the principal amount in regular intervals through monthly or quarterly payment plans instead of a lump sum payment at maturity.
Issuers of amortized debt instruments (bonds) also use this amortization cost strategy to offer discounts and sell these instruments quickly in the market.
Examples
Suppose a company has purchased a proprietary trading platform from a software development company for $0.5 million.
The company estimates that the trading platform remains useful for 10 years when it would need a total rehaul or an extensive upgrade and hence no salvage value.
The company uses a straight-line amortization method.
Yearly amortization expense = (Book Value – Salvage Value ) / Useful Life in Years
Yearly amortization expense = ($500,000 – $0) / 10
Yearly amortization expense = $50,000.
Now, suppose the company has charged this amortization expense for 5 years.
The total amortized cost for the company after 5 years will be $250,000 ($50,000 × 5).
Advantages of Using Amortized Costs
The concept of amortized cost has several advantages for its users.
- It is an acceptable and standard accounting practice to show the accumulated reduction of the total cost of an asset.
- It helps businesses spread the total cost of acquiring fixed assets over a long period with the accepted accounting principles.
- Amortized cost methods are in compliance with the GAAP and IFRS accounting rules.
- Without amortized costs, a business cannot estimate the book value of assets and the tax advantage by expensing the cost yearly.
- Without amortized costs, a business would have to charge the full cost of a fixed asset in a single year which isn’t possible under the accounting standards.
Challenges and Limitations of Using Amortized Costs
Despite several legal and accounting advantages, there are certain challenges and limitations of using the amortization cost strategies.
- The calculation of amortization, depreciation, and depletion charges is subject to accounting manipulation through estimations.
- Accountants can distort the depreciation and amortization calculations and therefore the amortization costs will not reflect an accurate picture of the account books.
- Estimation of the salvage value, useful life, and the choice of the method are all electives that can change the amortized cost significantly.
Accountants need regular revisions and adjustments to the amortization, depreciation, and depletion estimates which can be a challenging task.