When companies acquire financial assets, they must report them on their balance sheet. The value for these items initially comes from the costs associated with obtaining them. Later, however, companies must include them at a different amount. Accounting standards dictate what these amounts should be. Usually, this process falls under the amortized cost method.
What is Amortized Cost?
Amortized cost refers to the value of a financial asset or fixed asset on the balance sheet. It is an accounting method used to determine the value of these items. However, the definition of the amortized cost may vary based on the asset it impacts. Regardless of that, amortized cost represents the amortized value of an item on the balance sheet.
The amortized cost usually equals the acquisition cost of a financial or fixed asset on the balance sheet. However, this value only applies when a company acquires the item initially. Later, companies must also deduct some amounts from that value to reach the amortized cost. It may include principal repayments and discounts or premiums on that item. Similarly, it also accounts for impairment losses and exchange differences.
What is the Amortized Cost of a Fixed Asset?
The amortized cost concept also applies to fixed assets. Usually, it impacts intangible assets, although it can also relate to other resources. The amortized cost of a fixed asset represents the accumulated portion of its cost, expensed out through depreciation or amortization. For natural resources, it also refers to total depletion.
What is the Amortized Cost of Securities?
The amortized cost of securities differs from that of fixed assets. Here, it represents the security's cost adjusted for discounts and premiums associated with the purchase. It considers the difference between the purchase price of that security and its face value. If these values differ, the amortized cost will also vary based on the difference.
A purchase discount occurs when the face value of the security is higher than its purchase price. In this case, the effective interest rate will increase. Therefore, the amortized cost will account for that difference. A purchase premium is when the face value is lower than the purchase price. In this case, the effective interest rate will be lower.
Example
A company, Green Co., purchases a machine for $100,000, which it expects to use for ten years. By the fourth year, the company has charged $40,000 of the asset's cost through depreciation. This portion of the machine's cost represents the amortized cost for that asset. As stated above, it replaces depreciation with depletion of natural resources.
Green Co. also acquires 10,000 bonds with a face value of $100 and a 6% coupon rate. However, the company pays $96 per bond to receive it at a discount. In this case, the effective interest rate is 6.25% [($100 x 6%) / $96]. The company cannot report these bonds at $1,000,000 (10,000 bonds x $100). Instead, Green Co. will include it at its amortized cost of $981,815 in the balance sheet.
Conclusion
Amortized cost refers to the value of fixed or financial assets on the balance sheet. For the former, it represents the charge of holding the asset until that period. For financial assets, it involves the cost of security after accounting for discounts and premiums. The amortized cost concept is crucial in reporting assets in the balance sheet at their actual value.
Originally Published Here: Amortized Cost: Definition, Calculation, Examples
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