Amortization

Amortisation is a fundamental financial and accounting concept that refers to the systematic allocation of the cost of an intangible asset or liability over a specific period of time. In simple terms, it represents the gradual writing off of an asset’s value or the repayment of a loan through scheduled instalments. The term is derived from the Latin word amortire, meaning “to kill off” or “to bring to an end,” reflecting the process of gradually extinguishing an asset or debt.

Concept and Definition

In accounting and finance, amortisation can be understood in two main contexts:

1. In Accounting (Intangible Assets): Amortisation refers to the periodic reduction in the book value of intangible assets such as patents, trademarks, copyrights, goodwill, or software. These assets do not have a physical form but provide economic benefits over time. The process of amortisation spreads the cost of the asset across its useful life, ensuring that expenses are matched with the revenues they help generate.
2. In Finance (Loan Repayment): Amortisation also denotes the gradual repayment of a loan or debt through regular payments that include both interest and principal components. Over time, the interest portion decreases while the principal portion increases, until the debt is fully repaid by the end of the loan term.

Amortisation of Intangible Assets

Accounting standards such as the International Financial Reporting Standards (IFRS) and Indian Accounting Standards (Ind AS) require companies to amortise intangible assets with a finite useful life. The objective is to allocate the cost of the asset systematically over the period it provides benefits.
Examples of intangible assets subject to amortisation:

• Patents and copyrights
• Computer software
• Licences and franchises
• Development costs and design rights

Assets not subject to amortisation: Intangible assets with an indefinite useful life, such as goodwill, are not amortised but are tested annually for impairment.
Amortisation Formula:
Amortisation Expense per year=Cost of Asset−Residual ValueUseful Life\text{Amortisation Expense per year} = \frac{\text{Cost of Asset} – \text{Residual Value}}{\text{Useful Life}}Amortisation Expense per year=Useful LifeCost of Asset−Residual Value​
For instance, if a company purchases software for £100,000 with a useful life of 5 years and no residual value, the annual amortisation expense will be £20,000.
Accounting Treatment: Amortisation expense is recorded in the profit and loss account, while the accumulated amortisation is deducted from the intangible asset’s value in the balance sheet.

Amortisation of Loans

In financial management, amortisation refers to the method by which a borrower repays a loan in fixed instalments over its tenure. Each instalment covers both the interest and principal components. In the early years, the interest component is higher, while in later years, the principal repayment becomes dominant.
This repayment structure is commonly used for:

• Home loans
• Car loans
• Business term loans
• Equipment financing

Example of Loan Amortisation: Suppose a borrower takes a loan of £10,000 at an annual interest rate of 10% for 3 years. The loan is to be repaid in equal annual instalments. An amortisation schedule would show the breakdown of each payment into interest and principal, and the gradual reduction in the outstanding balance.
Amortisation Schedule:

This illustrates how amortisation ensures systematic repayment over time.

Methods of Amortisation

The method of amortisation depends on the nature of the asset or liability and accounting policies adopted by the organisation. Common methods include:

1. Straight-Line Method:
   • The most widely used approach.
   • The cost of the asset is spread evenly over its useful life.
   • Example: Annual amortisation of £10,000 for an asset worth £100,000 over 10 years.
2. Reducing Balance Method:
   • A fixed percentage of the asset’s declining balance is amortised each year.
   • Results in higher expenses in earlier years and lower expenses later.
3. Units of Production Method:
   • Amortisation is based on actual usage or production levels rather than time.
   • Suitable for assets whose benefits vary with activity levels.
4. Annuity Method:
   • Amortisation charge is computed to maintain a uniform total expense (including interest) each year.
   • Commonly applied to financial instruments or lease agreements.

Amortisation vs Depreciation vs Depletion

While all three terms refer to cost allocation, they differ in their application:

Significance of Amortisation

Amortisation plays a critical role in both accounting and financial management by:

• Matching expenses with revenues, thereby ensuring accurate profit measurement.
• Reflecting asset value reduction over time, giving a realistic view of financial position.
• Supporting loan management by providing clear repayment schedules.
• Ensuring compliance with accounting standards and tax regulations.

In corporate finance, amortisation also helps in cash flow forecasting, cost control, and investment decision-making.

Amortisation under Accounting Standards

• International Financial Reporting Standards (IFRS): Intangible assets are amortised over their useful lives unless indefinite.
• Indian Accounting Standard (Ind AS 38): Requires systematic allocation of the depreciable amount of an intangible asset over its useful life.
• US GAAP (ASC 350): Similar treatment; goodwill is not amortised but tested for impairment annually.

Amortisation expense is generally allowable as a tax-deductible expense, reducing a company’s taxable income.

Advantages and Limitations

Advantages:

• Provides a structured approach to asset cost recovery.
• Enhances accuracy in financial reporting.
• Facilitates planning for asset replacement.
• Reduces taxable income by recognising expenses periodically.

Limitations:

• Estimation of useful life and residual value involves subjectivity.
• Does not represent actual market value of the asset.
• Ignoring technological obsolescence can lead to understatement of expenses.

Applications in Business and Finance

Amortisation is applied in several business contexts, such as:

• Accounting for software and intellectual property rights.
• Loan amortisation schedules in banking and finance.
• Lease accounting, where right-of-use assets are amortised.
• Valuation of goodwill and acquisition-related intangible assets.