Introduction to Amortisation
amortisation is a financial concept that refers to the systematic allocation of the cost of an intangible asset over its useful life. This process allows businesses to gradually write off the value of an asset, spreading the expense over multiple accounting periods. amortisation is essential for accurately reflecting the consumption of intangible assets, such as patents, copyrights, and goodwill, in a company’s financial statements. By allocating the cost of these assets over time, amortisation helps businesses match the expenses incurred in acquiring the assets with the revenues they generate. This practice is in line with the matching principle, a fundamental concept in accounting that ensures financial statements provide a clear and accurate picture of a company’s financial performance (Horngren et al., 2017). In addition to intangible assets, amortisation is also applicable to certain financial instruments, such as loans and bonds, where the principal amount is gradually reduced over the life of the instrument (Weygandt et al., 2019).
- Horngren, C. T., Sundem, G. L., Schatzberg, J. O., & Burgstahler, D. (2017). Introduction to management accounting. Pearson.
- Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2019). Financial accounting: Tools for business decision making. Wiley.
Types of amortisable Assets
amortisable assets can be broadly categorised into tangible and intangible assets. Tangible assets are physical in nature and include items such as buildings, machinery, and equipment. These assets are subject to depreciation, which is the systematic allocation of their cost over their useful life. Intangible assets, on the other hand, are non-physical assets that provide economic benefits to a company. Examples of intangible assets include patents, copyrights, trademarks, and goodwill. These assets are subject to amortisation, which is the process of allocating their cost over their useful life or legal life, whichever is shorter.
Intangible assets can be further classified into definite-life and indefinite-life assets. Definite-life intangible assets have a finite useful life, such as a licence to produce a product for a specific period. These assets are subject to amortisation and may become impaired over time. Indefinite-life intangible assets, such as goodwill or certain broadcasting rights, have an unknown life at inception and may generate revenue indefinitely. These assets are not subject to amortisation but are subject to annual impairment tests (Kieso, Weygandt, & Warfield, 2019).
- Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate Accounting (17th ed.). Wiley.
Classification of Intangible Assets
Intangible assets are non-physical assets that hold value for a company, such as trademarks, customer lists, and goodwill. These assets can be classified into two main categories: definite-life and indefinite-life intangible assets. Definite-life intangible assets have a finite life, which can be determined at the time of acquisition. Examples include licences or patents with a specific duration. These assets are subject to amortisation, which is the process of allocating their cost over their useful life. On the other hand, indefinite-life intangible assets have an unknown life span at inception and may generate revenue indefinitely. Examples include goodwill and certain broadcasting rights that can be renewed without significant cost. Indefinite-life intangible assets are not subject to amortisation but are instead tested for impairment annually or when there is an indication of impairment. The classification of intangible assets is crucial for accurate financial reporting and compliance with International Accounting Standards (IAS 38) (IASB, 2021).
Determination of Asset Life
The determination of an asset’s life is a crucial aspect of amortisation, as it influences the allocation of costs over the asset’s useful life. Several factors contribute to the estimation of an asset’s life, including expected usage, product life cycle, technical obsolescence, competitor actions, and maintenance expenditure. Expected usage refers to the duration for which the asset is anticipated to generate benefits for the business or the length of the contract permitting the use of the intangible asset. The product life cycle plays a role in cases where intangibles are product-specific, ensuring that the asset’s life does not exceed that of the associated products. Technical obsolescence occurs when an asset becomes outdated due to advancements in technology, while competitor actions can render an asset obsolete if a rival introduces a superior product or service. Lastly, maintenance expenditure is considered, as some intangibles require ongoing costs to remain operational, and if these costs become unaffordable, the asset may need to be written down or off (IASB, 2022).
Amortisation Methods and Calculation
There are two primary methods for amortising intangible assets: straight-line amortisation and revenue-based amortisation. Straight-line amortisation is the most common method, where the cost of the intangible asset is evenly distributed over its useful life. To calculate straight-line amortisation, the initial cost of the asset is divided by its useful life in years, resulting in an equal annual amortisation expense. For example, if an intangible asset costs $100,000 and has a useful life of 10 years, the annual amortisation expense would be $10,000 ($100,000 / 10 years).
Revenue-based amortisation, on the other hand, allocates the cost of the intangible asset based on the proportion of revenue it generates. This method is more suitable for assets that contribute directly to revenue generation, such as patents or licences. To calculate revenue-based amortisation, the amortisation rate is determined by dividing the asset’s cost by the total expected revenue over its useful life. This rate is then applied to the actual revenue generated in a given period to calculate the amortisation expense. For instance, if an intangible asset costs $100,000 and is expected to generate $500,000 in revenue over its useful life, the amortisation rate would be 20% ($100,000 / $500,000). If the asset generates $50,000 in revenue during a specific period, the amortisation expense for that period would be $10,000 (20% x $50,000).
Straight-line amortisation is a method used to allocate the cost of an intangible asset over its useful life in a systematic and consistent manner. This method assumes that the asset’s value declines uniformly over time, and it calculates the annual amortisation expense by dividing the initial cost of the asset by its estimated useful life. The straight-line method is widely used due to its simplicity and ease of application, as it does not require complex calculations or assumptions about the asset’s future performance. However, it may not accurately reflect the actual consumption of the asset’s value in cases where the benefits derived from the asset vary significantly over its life. In such instances, alternative amortisation methods, such as revenue-based or unit-of-production methods, may be more appropriate to capture the asset’s true economic value and usage pattern (Atrill and McLaney, 2018; Weygandt et al., 2019).
- Atrill, P., & McLaney, E. (2018). Accounting and Finance: An Introduction. Pearson.
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2019). Financial Accounting: Tools for Business Decision Making. Wiley.
Revenue-based amortisation is a method of allocating the cost of an intangible asset over its useful life, taking into account the proportion of revenue generated by the asset. This approach recognises that the value of certain intangible assets, such as patents or licences, may be closely tied to the revenue they generate. By linking amortisation to revenue, this method aims to provide a more accurate reflection of the asset’s consumption and economic benefits.
To calculate revenue-based amortisation, the first step is to determine the total expected revenue to be generated by the intangible asset over its useful life. Next, the asset’s cost is divided by the total expected revenue, resulting in a revenue-based amortisation rate. This rate is then applied to the actual revenue generated by the asset in each accounting period, yielding the amortisation expense for that period. For example, if an intangible asset has a cost of $100,000 and is expected to generate $500,000 in total revenue over its useful life, the revenue-based amortisation rate would be 20% ($100,000 / $500,000). If the asset generates $50,000 in revenue during a specific accounting period, the amortisation expense for that period would be $10,000 (20% x $50,000). This method ensures that the amortisation expense is proportional to the asset’s actual revenue generation, providing a more accurate representation of its economic value.
Impairment of Intangible Assets
Impairment of intangible assets occurs when the carrying amount of an asset exceeds its recoverable amount, resulting in a reduction in the asset’s value on the balance sheet. The recoverable amount is the higher of an asset’s fair value less costs to sell and its value in use. Assessing impairment involves a two-step process. First, companies must perform an annual impairment test to identify any indications of impairment. Indications may include significant changes in the market, technological advancements, or internal factors such as changes in management strategy or poor financial performance.
If indications of impairment are present, the company must then estimate the recoverable amount of the intangible asset. This involves determining the asset’s fair value less costs to sell and its value in use, which is the present value of future cash flows expected to be generated by the asset. If the recoverable amount is less than the carrying amount, the company must recognise an impairment loss in its financial statements, reducing the carrying amount of the intangible asset to its recoverable amount (IAS 36, Impairment of Assets). This process ensures that intangible assets are not overstated on the balance sheet, providing a more accurate representation of a company’s financial position.
- International Accounting Standards Board. (2004). IAS 36 Impairment of Assets. Retrieved from https://www.ifrs.org/issued-standards/list-of-standards/ias-36-impairment-of-assets/)
International Accounting Standards
International Accounting Standards (IAS 38) play a crucial role in the amortisation of intangible assets by providing a comprehensive framework for their recognition, measurement, and disclosure. IAS 38 outlines the criteria for identifying intangible assets, distinguishing between those with definite and indefinite useful lives. For definite-life intangible assets, IAS 38 mandates the use of a systematic amortisation method over their useful lives, reflecting the pattern in which the asset’s economic benefits are consumed. If such a pattern cannot be determined, the straight-line method is applied by default.
IAS 38 also emphasises the importance of regular reviews of the useful lives, residual values, and amortisation methods of intangible assets, requiring adjustments if necessary. For indefinite-life intangible assets, IAS 38 prohibits amortisation but necessitates annual impairment tests to ensure that their carrying amounts do not exceed their recoverable amounts. Furthermore, IAS 38 prescribes specific disclosure requirements for intangible assets, promoting transparency and comparability in financial reporting. By adhering to IAS 38, companies can ensure that their intangible assets are accounted for consistently and accurately, enhancing the credibility of their financial statements (IASB, 2021).
Amortisation and Tax Implications
amortisation of intangible assets has significant tax implications for businesses. In many jurisdictions, amortisation expenses are tax-deductible, allowing companies to reduce their taxable income and, consequently, their tax liability. This tax treatment encourages businesses to invest in intangible assets, such as patents, trademarks, and copyrights, as the associated amortisation expenses can provide tax benefits over the asset’s useful life.
However, it is essential for businesses to adhere to the applicable accounting standards and tax regulations when claiming amortisation deductions. For instance, the International Accounting Standards (IAS 38) provides guidelines on the recognition, measurement, and disclosure of intangible assets, which may impact the tax treatment of amortisation expenses. Additionally, local tax laws may impose specific rules and limitations on the deductibility of amortisation expenses, such as the requirement to use a particular amortisation method or rate.
In conclusion, while amortisation of intangible assets can offer tax advantages for businesses, it is crucial to comply with the relevant accounting standards and tax regulations to ensure the appropriate tax treatment of these expenses (PWC, 2021; Deloitte, 2021).
- Deloitte. (2021). IAS 38 — Intangible Assets. Retrieved from https://www.iasplus.com/en/standards/ias/ias38
Amortisation Schedules and Reporting
amortisation schedules are essential tools in financial reporting, as they provide a systematic and detailed breakdown of the periodic payments made towards the principal and interest of a loan or intangible asset over its useful life. These schedules enable businesses and investors to track the progress of loan repayments and the reduction of the outstanding balance, as well as the allocation of interest expenses and the amortisation of intangible assets.
In the context of financial reporting, amortisation schedules serve multiple purposes. Firstly, they aid in the accurate calculation of periodic amortisation expenses, which are then recorded in the income statement, impacting the company’s profitability. Secondly, they assist in the determination of the carrying amount of intangible assets on the balance sheet, ensuring that these assets are not over or understated. Lastly, amortisation schedules provide valuable information for financial analysis, as they allow stakeholders to assess a company’s ability to manage its debt obligations and the efficiency of its investments in intangible assets.
Overall, amortisation schedules play a crucial role in ensuring the accuracy, transparency, and comparability of financial statements, ultimately contributing to informed decision-making by various stakeholders, including management, investors, and regulators.
- Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2015). Financial Accounting: Tools for Business Decision Making. John Wiley & Sons.
Real-World Examples and Case Studies
Real-world examples of amortisation can be found in various industries and contexts. One such example is the pharmaceutical industry, where companies often acquire patents for new drugs. These patents, which grant exclusive rights to produce and sell the drug for a specific period, are considered intangible assets with a definite life. The cost of acquiring the patent is amortised over its useful life, typically coinciding with the patent’s legal duration. For instance, if a company acquires a patent for $10 million with a 20-year legal life, it would amortise $500,000 annually using the straight-line method.
Another example can be observed in the media industry, where companies acquire broadcasting rights for sports events or television series. These rights, which grant the exclusive privilege to broadcast the content for a specified period, are also intangible assets with a definite life. The cost of acquiring these rights is amortised over the contract period. For instance, if a company acquires broadcasting rights for a sports event for $15 million with a contract period of five years, it would amortise $3 million annually using the straight-line method.
In both cases, the amortisation expense is recognised in the company’s financial statements, reducing the carrying value of the intangible asset and impacting the company’s net income.