Definition: The term amortized cost is used in business and finance to refer to the cost of a capital asset once incurred and typically determined using the straight-line method over time. This method is often used when analyzing the future cash flows associated with a particular capital asset to decide whether or not it is amortized cost or an expense.
The amortized cost of a capital asset represents the total future cash outflows due to operations, including repairs and maintenance, depreciation and depletion, replacement of parts, taxes, interest charges, and principal recoveries.
Amortized cost accounting is used in determining the cost of security, including a home security system, at the time of purchase. The company may offer a free evaluation to first-time buyers or make payments toward the cost after the initial evaluation period. The amortized cost is the payoff for the investment, less any upfront money paid. When investors use credit to buy securities with amortized costs, they are earning interest on the full face value of the investment even though they paid less than face value for it.
Amortized cost arises when an investor pays less than the face value of a security to increase the effective interest rate. At the same time, a purchase premium is paid when the interest rate paid on security higher than the market rate. An example of the amortized cost would be a loan with a premium that rises with each month that goes by instead of falling all at once. This premium for holding security is called an inflation premium and is calculated as a percentage of the security’s face value.
Amortized cost is a way of valuing an asset’s cost over time, making it easier to plan and deal with today’s market prices. It means that the assets outstanding at a particular point in time are valued at their face amount (the asset cost), not their present value (what it would be if the asset were sold now). This approach allows you to recognize gains from capital gains tax reduction or debt forgiveness, for example, even if the asset’s market value has risen since it was last sold.
In some ways, the amortized cost is like depreciation: the price paid for an asset depreciates with each use. Over time, however, the amortized cost has a more significant impact on your cash flow because it reduces the asset’s value faster than depreciation.
The more rapid rate of amortization, depreciation, or depletion will result in a higher amortized cost over time. This is good for businesses that plan to earn profits from the interest on their debt and are likely to incur new debt in the future to cover new costs. However, fast amortization can result in high debt once payments are due and interest accrues. Thus, it may be wise to consider alternative financing methods when choosing a debt strategy for your business.