What is Amortisation?
Amortisation or amortization, is the reduction in value of an intangible asset with a finite useful life over time. Its calculation is similar to that of straight line depreciation for a tangible fixed asset.
Most intangible assets have a limited finite useful life over which the benefit from them will be derived and therefore they need to be amortised over that lifetime.
An estimate of this amortisation is charged to the profit and loss account each accounting period and represents an expense of the business. In effect the expense of the intangible asset has been matched to the benefit derived from the same asset.
Amortisation can also refer to the repayment of the principal and interest on a loan by equal installments.
How to Calculate Amortisation
If for example, a business has a copyright to publications with a value of 100,000 and expects it to have a useful life of 10 years, then the amortisation would be calculated as follows:
In this example the amortisation is 100,000 / 10 years = 10,000 per year for the next 10 years.
The true purpose of calculating amortisation is to allow the business to set aside money from its profits in order to be able to replace the intangible asset at the end of its useful life. In the above case, after 10 years, 10 x 10,000 = 100,000 will have been treated as an expense in the income statement as amortisation and placed on the accumulated amortisation account in the balance sheet to remind the business that the funds will be needed to replace the intangible asset in 10 years time.
Amortisation Journal Entry
Amortisation is calculated at the end of an accounting period and is entered as a journal
The first entry is the charge to the profit and loss account as an expense, the second entry is to create a reserve in the balance sheet representing the funds needed to replace the intangible asset over time.
It is important to understand that although the charging of amortisation affects the profits (and therefore the amount attributable to shareholders) of a business, it does not involve the movement of cash. No actual cash is put aside, the amortisation reserve simply reflects that funds will be needed in the future to replace the intangible assets which reduce in value as the benefit received from them is utilised over time.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.