What is Amortisation?
Amortisation in accounting spreads the cost of intangible assets over a set period of time that is greater than one year. It means that the cost of the asset is matched with the revenue it generates over the years – this is part of the matching principle set out by Generally Accepted Accounting Principles (GAAP).
What is an Intangible Asset?
Unlike tangible assets, intangible assets have no physical state. They are a type of fixed asset in a business helping to generate business income.
Here are some examples:
How is Amortisation Calculated?
Amortisation spreads the intangible asset’s cost over its estimated useful life. In essence, it means that the cost of the asset is split over a number of years instead of being charged to the company’s income statement in the year of purchase.
Useful life means the estimated number of years an asset will remain in service to the business and contribute to income generation. The same definition of useful life is used for the depreciation of tangible fixed assets.
Amortisation Methods in Accounting
- Straight Line
- Reverse sum of digits
- Unit of production
The most common method used by businesses is the straight line but a company should choose the method that most accurately reflects their usage of the asset.
Straight-line spreads the cost of an intangible fixed asset over its useful life in equal amounts. The formula to calculate amortisation using the straight-line method is:
Amortisation = Cost ÷ Useful Life.
Here’s an example:
A business registers a patent costing £20,000 and it is estimated it has a useful life to the business of 10 years. Using the straight line method of amortisation, the patent will be amortised at £2,000 per year (£20,000 ÷ 10 years). The annual amortisation charge will be expensed to the company’s books.
Where Does Amortisation Appear on the P&L?
Amortisation charges appear in the profit and loss account, each financial period, over the useful life of the intangible asset. In the calculation above £2,000 would be charged to the profit and loss account, reducing profit. The equal and opposite entry would be to reduce the net book value in the intangible asset account in the balance sheet, reducing retained profit.
Dr Amortisation Charge (profit & loss account)
Cr Intangible Assets Amortisation Charge (balance sheet)
Amortisation is the method of spreading the cost of intangible assets are non physical assets. Depreciation refers to tangible fixed assets, which have a physical state such as computers, machinery, office furniture and buildings.
Amortisation is used to write off the cost of a company’s intangible assets such as trademarks and intellectual property.
Amortisation expense appears as a business expense in the income and expenditure account when calculating operating profit. Amortisation is not always tax deductible. An adjustment may be made to the company’s taxable income when calculating the business’s tax liability.