Contents
- What is Amortisation?
- Commencement and Cessation of Amortisation
- Choosing the Amortisation Method
- Choosing an Amortisation Method Based on the Predominant Limiting Factor
- Amortisation Based on Revenue Threshold
- Treatment of Amortisation in Financial Statements
- The Significance of Proper Accounting for Intangible Assets
- Difference Between Amortisation and Depreciation
- Amortisation Benefits and Drawbacks
What is Amortisation?
According to AASB 138, Amortisation is a financial accounting process that involves the systematic allocation of the depreciable amount of an intangible asset over its useful life. This concept is crucial for businesses to accurately reflect the consumption of the economic benefits associated with intangible assets in their financial statements.
Amortisation is not a one time expense but a gradual spreading out of the cost or value of an intangible asset over time. Instead of recognising the entire cost of the asset immediately, it is allocated in a structured and consistent manner across multiple accounting periods.
The depreciable amount refers to the value of the intangible asset that is subject to amortisation. It typically includes the initial cost of acquiring or developing the intangible asset, along with any additional costs necessary to bring the asset into a usable state. This amount is what the business intends to recover over the asset’s useful life.
Example
If a company acquires a patent for a new product that has a useful life of 10 years and the patent costs $100,000, it would amortise $10,000 each year (assuming a straight line amortisation method).
This means that $10,000 of the patent’s value would be recognised as an expense in the income statement every year for the next 10 years. This approach aligns the cost of the patent with the revenue generated by the product over its lifespan, providing a more accurate representation of the company’s financial performance.
Commencement and Cessation of Amortisation
Amortisation begins when an intangible asset becomes “available for use.” This means the asset must be in a suitable location and condition, ready to serve its intended purpose. It’s the point at which the business starts recognising the gradual expense associated with the asset’s consumption over time.
Amortisation continues until certain conditions are met:
- Held for Sale: If the business intends to sell the asset, it is classified as “held for sale” following the guidelines in AASB 5. This marks a change in the asset’s status and the amortisation stops.
- Derecognition: The asset is derecognised when it is no longer recognised as an asset on the company’s balance sheet. This typically occurs when the asset is disposed of or reaches the end of its useful life.
Choosing the Amortisation Method
When deciding how to amortise an intangible asset, it’s crucial to select an appropriate method that aligns with the expected pattern of how the asset’s future economic benefits will be consumed. The chosen method should accurately reflect the economic reality of the asset.
Straight Line Method
This method spreads the amortisation expense evenly over each accounting period. It’s straightforward and is often used when the asset’s expected consumption pattern is relatively consistent.
Diminishing Balance Method
Under this approach, amortisation expenses are higher in the initial periods of asset use and decrease over time. It is suitable when the asset’s economic benefits are anticipated to decrease as it ages.
Units of Production Method
This method links the amortisation expense to the level of output or usage of the intangible asset. It is suitable when there is a direct correlation between the asset’s consumption and production or usage levels.
Consistency in Application
AASB 138 explains the importance of maintaining consistency in the chosen amortisation method from one accounting period to the next. Consistency in application ensures that financial statements can be compared over time, providing stakeholders with a clear and reliable view of the company’s financial performance.
Choosing an Amortisation Method Based on the Predominant Limiting Factor
When deciding on the most suitable method for amortising an intangible asset, a business can consider the primary factor that limits the asset’s use.
For instance, if the contract governing the intangible asset specifies that it can be used for a fixed number of years, a certain number of units produced, or until a set revenue target is achieved, this limiting factor can guide the choice of the amortisation method.
However, it’s essential to pick a method that closely matches how the economic benefits of the asset are expected to be consumed.
Amortisation Based on Revenue Threshold
As per AASB 138, in cases where the main limiting factor inherent in an intangible asset is achieving a specific revenue threshold, the revenue generated by the asset can be a suitable basis for amortisation.
For example, if a business acquires a contract to extract gold from a mine, and the contract’s duration is based on reaching a predetermined total revenue (e.g., $3 billion) rather than a specific time period or quantity of gold extracted, then using revenue as the basis for amortisation is appropriate.
Similarly, if the right to operate a toll road is contingent on reaching a fixed revenue amount (e.g., $200 million) from toll charges rather than a specific time frame, revenue-based amortisation can be applied.
Treatment of Amortisation in Financial Statements
In most cases, the amortisation expense is recognised in the company’s profit or loss statement. It is a straightforward way to account for the gradual consumption of the intangible asset’s value over time.
However, there are instances where the future economic benefits from the asset are absorbed in producing other assets. In such cases, the amortisation expense is considered a part of the cost of those other assets and is included in their carrying amounts.
For example, if an intangible asset is used in the production process of inventories (as mentioned in AASB 102 Inventories), the amortisation expense is added to the cost of those inventories.
This approach ensures that the cost of producing the inventory reflects not only the direct costs but also the indirect costs associated with using intangible assets in the production process.
The Significance of Proper Accounting for Intangible Assets
Intangible assets, like patents or trademarks, are vital parts of a company’s value and are recorded on the balance sheet at their cost. These assets are typically amortised, which is spreading the expense over their useful life.
However, there are exceptions: internally generated intangible assets and those with indefinite lives are not amortised.
If a company fails to correctly identify and recognise these intangible assets, they might not be listed on the balance sheet. Instead, they could be grouped under a category called goodwill. This matters because goodwill isn’t subject to amortisation, and this can affect a company’s taxable income.
Furthermore, how these assets are accounted for can also influence how potential investors or buyers perceive the company’s overall value.
So, accurate accounting of intangible assets is not just a matter of bookkeeping; it can have a real impact on a business’s financial health and its valuation in the eyes of investors and stakeholders.
Difference Between Amortisation and Depreciation
Amortisation and depreciation are essential accounting concepts that share the goal of spreading asset costs over time. However, they apply to different types of assets and have distinct reasons for reducing an asset’s value.
Nature of Assets
- Amortisation: Applicable to intangible assets such as patents, copyrights, or brand values, which lack physical presence but possess significant value for businesses.
- Depreciation: Pertains to tangible assets like machinery, vehicles, or buildings, encompassing physical, touchable assets.
Reasons for Value Reduction
- Amortisation: Reflects the gradual devaluation of intangible assets, often stemming from factors like contract expiration or technological obsolescence.
- Depreciation: Concerns the wear and tear or depletion of value in tangible assets due to physical use or ageing. For instance, a vehicle’s worth diminishes as it accumulates miles and endures wear.
Applicability
- Amortisation: Reserved for intangible assets with finite, identifiable useful lives and doesn’t extend to assets with indefinite useful lives.
- Depreciation: Relevant to all tangible fixed assets, excluding land. It encompasses assets ranging from office equipment to physical structures like buildings.
Salvage Value
- Amortisation: Typically assumes that the entire value of an intangible asset will be entirely consumed or depleted.
- Depreciation: Considerations often account for the possibility of a tangible asset retaining some salvage or residual value when it’s no longer in use.
Journal Entries
- Amortisation: The accounting process for amortisation involves recording an expense on the income statement. This expense is debited to the Profit and Loss (P&L) expense account, accompanied by a corresponding credit directly to the intangible asset account on the balance sheet.
- Depreciation: In the realm of depreciation, the accounting entry credits an account known as “Accumulated Depreciation,” a contra-asset account. This credit offsets the original cost of the asset on the balance sheet.
Thus, while both amortisation and depreciation serve the purpose of aligning asset costs with accounting principles over time, they diverge in asset types, reasons for value reduction, and accounting treatment.
Depreciation revolves around tangible assets’ decline due to physical factors, whereas amortisation addresses the decline in value of intangible assets, often influenced by various factors such as contracts and technology shifts.
Amortisation: Benefits and Drawbacks
Amortisation is neither inherently good nor bad; it’s a financial tool with both advantages and disadvantages.
Benefits
- Tax Reduction: One significant advantage of using amortisation is that it can lead to reduced taxes for a business in the current tax year. By spreading the payments of intangible assets or loans over time, businesses are entitled to deductions on their taxes. This can lower taxable income, resulting in reduced tax liability.
- Tax Break Over Time: The benefit doesn’t stop with a single year. As long as a business is using the asset or repaying the loan, it can continue to gain a tax break. This can be advantageous for businesses over multiple accounting periods.
- Enhanced Financial Statements: Amortisation also affects a company’s financial statements positively. By gradually expensing the asset’s cost over time, the income statement shows lower expenses, potentially leading to higher reported profits. Additionally, the balance sheet reflects increased assets, improving the financial position.
Drawbacks
- Slow Process: Amortisation involves the gradual repayment of a loan or the allocation of an asset’s cost over an extended period. While this can reduce tax payments, it can also make the process slow and extended. This prolonged timeline may not be suitable for businesses needing immediate financial relief or benefits.
- Cash Flow Challenges: Depending on the payment schedule or method chosen for amortisation, some payment periods may require significant cash outflows. This can strain a business’s cash flow, impacting its ability to cover other operational expenses or invest in growth opportunities.
Hence, the decision to use amortisation depends on a business’s specific circumstances and financial goals. Businesses should carefully weigh the pros and cons to determine if amortisation aligns with their financial strategies and needs.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.