Do You Know the True Value of Your Assets and Liabilities?
Do you know how long you will have them? Amortisation is the method we use to answer these questions.
Amortisation is a term we frequently use, which can create confusion when referring, for example, to the amortisation of an asset or a loan.
The first thing we need to understand is the meaning of the term amortisation. If we refer to a loan, it is the process of repaying debt over time through regular payments. These payments may include both the principal (the amount borrowed) and the interest. Amortisation helps reduce the total debt until it is fully paid off. The term is also used in accounting to describe the decrease in the value of an asset over its useful life.
To understand the financial term amortisation correctly, it is important to identify whether we are talking about an asset or a liability.
Amortisation of Assets
Accounting assets are economic resources owned by a company that are expected to generate future benefits. These assets can be tangible, such as buildings, machinery, inventory, etc.
These are goods for which we pay money to fulfil a specific purpose.
Over time, these assets lose value; they have a useful life for which they were designed, which diminishes due to wear and obsolescence. For example, if we purchase a computer with a useful life of 5 years, by the end of that period, it will be amortised because it will have served its function for the time it was intended. Its initial value decreases until it reaches the end of its useful life.
To determine the amortisation value of the computer in our example over its 5-year useful life, we can use the most common formula (there are others), which is straight-line amortisation. This involves dividing the computer’s value by its useful life in years. If the computer cost £500, the amortisation for the first year will be £100; in the second year, £200; in the third, £300; and so on, until the value is fully amortised by the end of its useful life. If the computer still functions beyond its useful life, this extra time is referred to as residual value.
Amortisation of Liabilities
Liabilities refer to financial obligations we have, such as a consumer credit or a mortgage. When we talk about amortisation in these cases, we mean the gradual reduction of the debt through the instalments we pay to the bank. Typically, we are not referring to the interest generated, just the principal value.
Most Common Methods of Liability Amortisation
- French amortisation system: This involves fixed instalments, where the same amount of money is repaid each month until the obligation is fully settled.
- Growing amortisation system: Instalments start at a lower amount but increase over time as the obligation progresses.
- Decreasing amortisation system: A portion of the debt itself is paid off from the beginning, so the interest generated on the remaining principal decreases, resulting in lower instalments.
Understanding amortisation is essential as it helps us know the true value of assets and liabilities. It enables us to make optimal economic decisions, avoiding mistakes such as taking on debts to purchase assets that will lose value before they are fully paid off. If you have questions about how to do this, feel free to contact us by completing the form.
