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. Accordingly they 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
To illustrate suppose a business has a copyright for its publications. Additionally the copyright has a value of 100,000 and the business expects it to have a useful life of 10 years. In this case the calculation of the amortisation is as follows:
Consequently 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 profits to reflect the reduction in value of the asset over its lifetime. In this 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
The calculation of the amortisation at the end of an accounting period results in the following journal.
| Account | Debit | Credit |
|---|---|---|
| Amortisation expense | 10,000 | |
| Accumulated Amortisation | 10,000 | |
| Total | 10,000 | 10,000 |
As can be seen the first entry is the charge the amortisation 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.
Conclusion
It is important to understand that although the charging of amortization 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 amortization 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.