Amortization is the paying off a debt in regular installments over a period of time. It may also refer to expensing the acquisition cost less the residual value of certain intangible assets in a systematic manner applied by a company over the useful life of the asset. This is to reflect the consumption or decline in value of the intangibles as a result of the passage of time. However, some intangibles like goodwill may not be subject to amortization because they are sometimes deemed to have an indefinite useful life.
An example would be: Ayala Company issued a note worth $ 100, 000 as additional capital payable in 1 year at the rate of 10% per annum. Monthly amortization, which will constitute the interest payment, will be $833.33 computed as [($100,000)(10%) / 12 months].
Depreciation, on the other hand, is a non-cash expense recorded to allocate a tangible assets cost over its estimated useful life. This is recorded to match the expenses of the asset to the revenue that the asset helps the company earn (cited in Valix, 2006). Depreciation is made because the worth of the assets (except land) are constantly reduced or loses its value over time. Because it is has a non-cash nature, it increases free cash flow and reduced net income.
For instance, Ayala Company purchases a delivery truck for $ 25,000, with a salvage value of $ 5000 and an estimated useful life of 10 years. Using the straight-line method, depreciation for the delivery truck would be $ 2000 annually computed as [($25000-$5000) / 10 years]. This $2000 will serve as the depreciation expense for the year, and at the same time added per year to the accumulated depreciation of the delivery truck, which is a contra-asset account or which reduces the value of the asset.
Amortization and deprecation are two distinct concepts in accounting, which are often used interchangeably. This is technically incorrect because “amortization refers to intangible assets and depreciation refers to tangible assets” (“Amortization”).
The manufacturer’s sale of furniture to Simon and Hobbs for $10,000 was made late in year 2000. However, the receipt of the goods will still be on January 2001. The store is ineligible for the sale of the furniture to the Simon family since the transaction is considered invalid. This is primarily because the furniture was not yet actually received thereby there was nothing yet to sell. Moreover, even if the terms of the purchase from the manufacturer was either FOB Shipping Point or Destination, ownership is not yet entitled to Simon and Hobbs, making the sale to the Simon family ineffectual.
Simon also instructs the accountant not to record year-end adjustments for the store namely the salaries owed to the employees worth $9,000 and expired insurance worth $400. Since the store has experienced a decreased income, Simon took these fraudulent actions to be able to conceal the expenses of the store, thereby making it look that cash is higher, there are no longer liabilities for the employee salaries, there are no salaries and insurance expenses and there is higher amount of assets specifically prepaid insurance.
This is an action where Simon will tend to understate Simon and Hobbs expenses and payable, and overstating his assets (prepaid insurance). If the accountant will really not record these transactions, Simon and Hobbs financial statements will show a higher amount of net income and total assets compared to the net income and total assets if the adjusting entries would be correctly journalized.
A substantial decrease in the net income of Simon and Hobbs may induce the owner, Carol Simon, to take actions that may give a lift to the store operations and financial position and performance. And for Simon, her unethical actions include violating some accounting standards by persuading her accountant not to record significant business transactions. This course of action is fraudulent and violates the standards of the practice of accounting that is required from business entities.
Every accountable or quantifiable information or transaction that happens and affects the store must be recorded and disclosed accordingly. Her actions of covering up for the store’s expenses may actually show higher income for Simon and Hobbs. However, this act may cause detriment or harm to the business entity itself. How? Naturally, if the accountant records fraudulent transactions, or does not record true transactions, the store’s financial statement will not truly show the actual performance of the entity.
These financial statements are intended to be useful in making economic decision; therefore if these are misrepresented and decisions are based on these defective statements, righteous decisions about the store may not be generated and incorrect decision may be made, which will injure the operations and eventual success of the store itself.
“Amortization”. Investopedia. Retrieved November 6, 2007 from http://www.investopedia.com/terms/a/amortization.asp.
Brock, H., & Cunningham, B.M. (1986). Accounting: Basic Principles. Westerville, OH: Glencoe/McGraw-Hill.
Valix, C. (2006). Financial Accounting 1. Philippines: Conanan Educational Supply.