BACKGROUND TO AMORTIZATION IN ACCOUNTING
The term amortisation is used in both accounting and finance.
In finance, amortisation describes a process of gradually reducing debt through systematic payments at regular intervals until the debt is gone. In accounting, amortisation specifically refers to the process of expensing the
value of the intangible assets of the business over a period of time.
Not all the assets of a business are physical or tangible. Some assets are non- physical and are called intangible assets.
For example, patents, trademarks, brands, goodwill, copyrights, licenses, computer software, costs of incorporation and internet domains are all intangible assets.
Even though these assets are invisible (or cannot be touched), they still
contribute to the revenue growth of a business and so must be expensed against the revenues as they are earned. Intangible assets are treated in the same way as physical assets that are depreciated (expensed) and so their value is
systematically transferred from an asset on the Balance Sheet item to an expense item (Amortisation) on the Income Statement.
mortisation reflects the
consumption, expiration,
obsolescence or other decline
in value of the intangible asset
as a result of use or the
passage of time.
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KeyFACTS
Amortisation is underpinned by the matching principle in accounting.
The matching principle in accounting ensures that the financial reports of the business give an accurate view of the financial position and performance of the business to the decision-making stakeholders of a business.
Under the matching principle, accountants are required to match the revenue for each accounting period with the actual expenses incurred in earning that revenue for the period.
In the example in the ‘for example’ box on the next page, it would not give an accurate view of the profitability of the business if the patent costs were expensed only in the year the costs were paid. Also, a Balance Sheet that
view of the value of that asset, given that its value is just 12 months away from being worthless. So, instead of taking either of the two options listed above, accountants will amortise the cost of the intangible asset over the estimated useful economic life of the intangible asset.
The process of amortisation, then, gives a more accurate view of the financial performance and position of the business to the decision-making stakeholders of the business.
APPLICATION OF AMORTISATION IN ACCOUNTING
Under International Financial Reporting Standards, guidance on accounting for the amortisation of intangible assets is contained in IAS 38.
Not all intangible assets are amortised. Some intangible assets may be
considered to have an indefinite useful economic life and are considered to offer continual earning potential to the business for the foreseeable future. A domain name and brands could be included in this category.Either way these intangible assets with an indefinite useful economic life still need to be assessed each year to make sure that their value in the Balance Sheet is not overstated. This
checking process is called the impairment test.
The method used to amortise those intangible assets with a set useful economic life is the straight-line method—that is, where the cost of acquiring the intangible asset is written off (amortised) over the estimated useful economic life of the asset.
For example, if the business had spent $20,000 in legal fees to secure a patent that gave the business certain rights over the next 20 years, the value of the intangible asset (Patents) would be expensed or amortised by $20,000/20years = $1,000 each year for the next 20 years. This means that $1,000 would appear each year in the Income Statement as Amortisation expense, with a corresponding adjustment being made directly to the intangible asset Patents in the Balance Sheet. (Note: Unlike depreciation of tangible assets, intangible assets do not have a contra account called Accumulated Amortisation. The unamortised/unimpaired cost of intangible assets is positioned in a separate section of the Balance Sheet immediately following Property, Plant and Equipment.)
AMORTISATION PERIODS OF INTANGIBLE ASSETS IN ACCOUNTING
The amortisation period selected can have a significant impact on the reported income for a business. The shorter the estimated useful economic life, the
greater the amortisation expense and therefore the lower the net profit reported. So, it is important that the amortisation period closely matches its revenue generation capacity.
Figure 36 presents some examples. Copyrights give owners the exclusive right to produce or sell an artistic work. While a
copyright has a legal life equal to the life of the creator + 70 years, the economic useful life is usually much shorter. The shorter economic life is the appropriate amortisation period Patents provide owners an
exclusive right to use or manufacture a particular product. The cost of a patent should be amortised over its useful life but not exceeding the patent’s legal life of 20 years. The Patent account should include only the cost of a patent purchase and costs relating to the registration of the patent, like legal fees.