Amortisation of Assets Explained for Dummies

What is amortisation?

Generally, amortisation refers to the process of paying off a loan through predefined installments that include both the principal and interest on the loan account.

Expressed differently, the amortisation of debt[1] is the process of spreading out a loan over a certain period, using several regular payments.

There is also another situation in which amortisation is applicable – the amortisation of assets, particularly intangible assets. It refers to the accounting practice of spreading an intangible asset’s capital expenses over its useful life. (This article will focus on this type of amortisation.)

The International Financial Reporting Standards (IFRS) defines amortisation as ‘the systematic allocation of the depreciable amount of an intangible asset over its useful life.’ [2]

Useful life refers to the duration an intangible asset contributes to the value of a business.

Amortisation can also be spelled ‘amortization’.

What is an intangible asset?

An intangible asset is an identifiable non-monetary long-term asset that lacks physical substance, although essential to a company. Examples of intangible assets are:

• Goodwill.
• Intellectual property such as:
• Patents.
• Trademarks.
• Brand names.
• Copyrights.
• Franchise agreements.
• Trading licences.

In accounting, goodwill refers to an intangible asset that emerges when a buyer acquires an existing business with a history of well-managed operations that provide good results.

According to IFRS, ‘goodwill is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognised.’

Contrary to intangible assets, tangible assets are of a physical nature like land, vehicles, and equipment.

Classification of intangible assets

Based on lifespan, intangible assets are broadly categorised into two types:

• Limited life

Indicates assets with a limited life, also referred to as definite life. For instance, a trade licence that allows a company to manufacture a certain product for a specified number of years. Other tangible assets with a limited life are patents, copyrights, and trademarks.

• Indefinite life

The lifespan of these assets is unknown at acquirement. They have the possibility to generate income in perpetuity. For example, a company’s brand name can last as long as a company is in business. Other intangible assets with an indefinite life are goodwill and perpetual franchises.

Amortisation of intangible assets

Like tangible assets, intangible assets can lose value due to use, expiration (contracts coming to an end), or obsolescence over time.

Intangible assets are amortised to indicate the decline in value over time, matching the expense of acquirement with the revenue it generates.

Intangible assets with a limited life

An intangible asset with a limited life is systematically amortised throughout its useful life. Typically, by using the straight-line method (SLM), similar to the depreciation of tangible assets.[3] The straight-line method implies that the same amount of an asset’s value is expensed in each year of its useful life.

Put differently, when an asset’s expenses are amortised over time, the cost of using the asset is tied to the revenues it generates in the same accounting period. This is done to be compliant with generally accepted accounting principles (GAAP).

Contrary to tangible assets, intangible assets that are amortised do not have any salvage value, which is an asset’s estimated resale value at the end of its useful life.

The annual amount expensed is recorded in the accounting system of a business via an accounting entry in which the amortisation expense account is debited and the accumulated amortisation account is credited.

Concerning the financial statements:

• Income Statement: The amortisation expense is reported as an expense against operating profit, affecting a company’s reported net income (earnings).
• Balance Sheet: The annual amount of the amortisation expense is deducted from the asset’s fair value to reflect its current value, while it increases the accumulated amortisation.

Indefinite-life intangible assets

Indefinite-life intangibles are not amortised because the cash flows generated by them are unlimited.

Instead of amortisation, these assets are evaluated for impairment annually, as well as any time a company’s management suspects that the asset may be impaired.

Generally accepted accounting principles (GAAP) require that the values of intangible assets be re-evaluated at least annually.

Impairment occurs when an intangible asset’s fair market value is determined to be less than its current value minus the amortisation expense, also known as the carrying value.

When this happens, the difference between the asset’s fair market value and its current value is determined as an impairment loss, also referred to as an impairment charge, which must immediately be written off as a loss.

The maximum impairment loss cannot exceed the carrying value. Put differently, the intangible asset’s value cannot be reduced below zero or recorded as a negative number.

For example: Company CZH’s annual re-evaluation of the company’s intangible assets indicates that its goodwill (carrying value = R3 000 000) incurred an impairment loss of R500 000. The impact of the loss will be as follows:

• Impact on Income Statement

An impairment loss of R500 000 is recorded, reducing net earnings by R500 000.

• Impact on Balance Sheet

The intangible asset, goodwill, reduces from R3 000 000 to R2 500 000.

[1] Refer to the article, ‘Amortisation of Debt Explained for Dummies’, for more information about this type of amortisation.

[2] Accentuations in citations, as well as other accentuations, are by the article writer.

[3] Refer to the article, ‘Assets Explained for Dummies’, for more information about the different depreciation methods for tangible assets.