What is amortisation in accounting?

Business accounting and finance is full of jargon. Key terms and concepts that aren’t well explained can lead to miscommunication, misunderstandings, loss of control, and missed opportunities.

As part of a new jargon-busting series, we’ll be taking you through some of the most commonly employed jargon in accounting, starting with amortisation.

What does amortisation mean?

In accounting, amortisation is the process of reporting the cost of an intangible asset over the estimated duration of its useful life, not as a single upfront expenditure. It means the payment is made, but the cost is accounted for in instalments.

This is done for several reasons, which will be outlined below. Amortisation is typically used when the asset's useful life is limited (such as several years).

What is an intangible asset?

Unlike tangible assets, like buildings and machinery, intangible assets are non-physical assets with value from their rights or benefits. Intangible assets include patents, copyrights, trademarks, goodwill, and leasehold improvements.

Are all intangible assets subject to amortisation?

Not all intangible assets are amortised if they have indefinite useful lives. Those assets are not amortised but are tested for impairment annually to ensure they are held at the correct value.

What happens when an item is fully amortised?

When you realise the full value of an intangible asset, its value on your balance sheet should reach zero. From there, it no longer contributes to your company's total reported net assets and from an accounting perspective the asset has no value. 

You can continue to use the intangible asset, but you won't record any extra expense for it. 

What is the purpose of amortisation?

Amortisation is used to spread the cost of an intangible asset over its useful life, helping businesses align the expense of that asset with the income or value it generates over time. This provides a more accurate and consistent view of a company’s financial performance.

Without amortisation, the full cost of an intangible asset could remain on the balance sheet without being appropriately recognised as an expense in the profit and loss account. This may lead to the asset and profits being overstated and financial results not reflecting the true cost of generating revenue.

Amortisation is also an important accounting requirement. Failing to account for it correctly could result in financial statements that do not comply with applicable accounting standards, potentially leading to regulatory issues, audit concerns, and a less reliable picture of the business’s financial position.

What is the amortisation process?

When accounting, amortisation typically includes the following steps.

1. Consider the initial cost of the intangible asset, factoring in the purchase price, legal fees, and associated expenses.

2. Determine the estimated useful life of the intangible asset. This is the period over which the asset is expected to provide economic value or benefits to the business.

3. The cost of the asset is then allocated over its useful life period. This results in an annual amortisation expense recorded on the Profit & Loss Report.

A quick example of amortisation

Suppose you acquire an intangible asset, such as a patent. The patent costs £40,000 and is valid for 10 years.

This will give you £4,000 of amortisation per year for the 10-year useful life of the patent. The patent cost of £40,000 is divided into 10 years (or 10 separate reported expenditures).

This gives a more accurate picture of how much the asset costs you each year rather than recognising the entire cost in the year of purchase.

Amortisation does not change the actual cost of the intangible asset – it only spreads that cost over the asset’s useful life for reporting purposes. You would still be paying £40,000 for the asset at the time of purchase.

What is the “useful life” of an intangible asset?

The useful life of an intangible asset, such as a patent, copyright, or goodwill, estimates how long it is expected to provide economic benefits to a company.

The useful life of an asset can be affected by its type, the industry in which it operates, and legal or contractual terms. Technological advancements could also change the useful life of an asset if they render it obsolete.

Can amortisation be changed after it begins?

Amortisation schedules can be changed if there is a significant change in the asset’s useful life or its residual value. This change is considered a change in accounting estimate and is applied prospectively.

Asset amortisation vs loan amortisation

You may hear these terms mentioned often, and while they have the same function (spreading a large sum across a specific time period) they refer to distinct financial functions. Asset amortisation is used in accountancy to spread the cost of an intangible asset over its lifetime. This helps you determine the asset's cost alongside the revenue it creates over that time period. 

Loan amortisation is essentially a debt repayment structure. When you take out a loan, its generally divided between the amount you borrowed (the "principal") and the "interest" (cost of borrowing that sum of money). Early in the process, you will pay a higher amount of interest. As you chip away at the loan over time, the interest will decrease and you will pay more of the principal amount. 

Why should you care about amortisation for your business?

Some may view amortisation as a bookkeeping exercise, but it can have a significant impact on your business's financial performance and forecasting. By spreading the cost of your intangible assets over the course of their lives, it can provide a more accurate portrayal of your annual profitability. 

Finally, amortisation can help you monitor the remaining value of your intangible assets. 

How is amortisation reported in financial statements?

Amortisation expense is reported on the Income Statement as part of operating expenses. The accumulated amortisation is reported on the balance sheet as a deduction from the intangible asset's value.

Does amortisation affect cash flow?

Amortisation itself does not affect cash flow because it is a non-cash expense. However, it reduces the net income, which in turn affects the cash flow from operations indirectly when calculating the operating cash flows using the indirect method. Our guide on EBITDA explains how amortisation impacts earnings in more detail. 

What is impairment?

There may be occasions when an asset is worth less than what it is recorded for on a company balance sheet. This is known as impairment. In other words, impairment is when an intangible asset's carrying value (the asset's cost minus accumulated amortisation) has exceeded its recoverable amount.

If an intangible asset is deemed to be impaired, the company must recognise it as an impairment loss (reducing the asset's carrying value to its “recoverable amount”) and adjust future amortisation (the remaining useful life of the asset may need to be reassessed).

The “recoverable amount” is whichever is higher out of:

• The price that could be obtained from selling the asset
• The present value of the future cash flows expected to be derived from the asset.

Accounting for intangible assets must consider impairment to ensure the assets are carried at their recoverable amount. This provides a more accurate representation of the company's financial position.

What is the difference between amortisation and depreciation?

Amortisation and depreciation are similar concepts that involve the systematic allocation of an asset's cost over its useful life.

Amortisation applies to intangible assets such as patents, trademarks, and goodwill, whereas depreciation is specifically used for tangible assets like buildings, machinery, and vehicles.

This distinction is important because it reflects the differing nature of these assets and how their values change over time. Intangible assets lose their value over time due to obsolescence or legal limits, whereas tangible assets experience wear and tear or become outdated.

FAQs

Where does amortisation go on P&L?

Generally, amortisation is listed as an operating expense on the Profit and Loss statement. 

What are the disadvantages of amortisation?

While amortisation can improve cash flow management, it does have some drawbacks. While you can report the cost of an intangible asset across its useful life, the lifespan estimates can be subjective and may not reflect the asset's actual usage. Amortisation also fails to take into account market value fluctuations of intangible assets as well. 

How do you record amortisation?

You can record amortisation as an operating expense or Cost of Goods Sold in your Income Statement. 

What is "good" amortisation?

The definition varies depending on your amortisation goals, but "good" amortisation in accounting can generally refer to accurately reporting the lifespan of an intangible asset.