Important accounting methods used to guarantee an exact depiction of a company’s financial situation and performance are depreciation, amortisation, and depletion. These methods divide the cost of long-lived assets throughout their usable life so that costs are aligned with the income they generate. Reflecting their total wear and tear, depreciation applies to physical assets, including machinery, cars, and structures. Over time, they offer economic benefits, and amortisation is the dispersion of the cost of intangible assets, including patents, goodwill, and software. Depletion, conversely, is the slow deterioration of natural resources, including oil and minerals.
These accounting procedures guarantee that assets are not stated at excessive levels and assist in avoiding overstatements of profits. Moreover, they adhere to the matching theory as well as the concept of accruals, which are very important for accurate financial reporting. Using these systematic techniques, businesses in their financial statements may show a true and fair picture of their profitability, asset values, and financial condition.
What is Amortisation?
The accounting technique of spreading the cost of an intangible asset over its useful life is called amortisation. By spreading the cost of an intangible asset over time, amortisation guarantees that the cost of using an asset— goodwill, patents, copyrights, trademarks, software or licenses is distributed over periods of time when it is most helpful, not expensed in one lump sum.
Amortisation is the reduction in value of an intangible asset as it deteriorates or becomes obsolete over time from use. The idea is identical to depreciation, except that intangible assets—like buildings or machinery—are substituted for tangible assets.
By and large, the method used is the straight-line method, whereby an equal amount is charged as an expense each year. The expense is recognised in the Profit and Loss Account, and the entire amount is deducted from the asset’s value on the balance sheet.
The primary aim of amortisation is to achieve correct profit reporting, associate the cost with revenue, and represent asset value correctly. In India, it is governed under Accounting Standard (AS) 26 – Intangible Assets or IND AS 38, depending upon the accounting standard used by the entity.
Amortisation of a Loan
The procedure of repaying a loan within a given period using equal instalments covering both the principal and the interest is known as loan amortisation. Every payment reduces the overall loan amount; more goes toward interest in the first few years and more toward the principal in later years.
An amortisation schedule shows how each payment is split between interest and principal. This technique ensures maturity guarantees total repayment of the loan.
Among the often-used monthly EMIs (Equated Monthly Instalments) are home mortgages, vehicle loans, and company loans; the loan amount, interest rate, and tenor specify these EMIs.
Bookkeeping’s loan amortisation tracks the fall in interest expense and debt over a period. It lowers debt both systematically and naturally by facilitating budgeting and guaranteeing prompt repayment.
Amortisation of Intangible Assets
Amortisation of intangible assets is the systematic apportionment of the cost of an intangible asset over its useful life. Intangible assets that yield long-term economic benefits include patents, trademarks, copyrights, goodwill, licensing, and software.
The main purpose of amortisation is to equate the asset’s cost to the revenue generated by it every year, thus making it easier to accurately measure profit. This is usually done by applying the straight-line basis, where the same expense is posted in each year for the asset’s expected useful life.
In accounting, the amortisation cost is indicated in the profit and loss account, and accumulated amortisation is offset against the asset value in the balance sheet. If the useful life cannot be established, under Accounting Standard (AS) 26 in India, it should never be more than ten years. This approach helps to give a true and fair view of the financial position of an organization.
Calculation of Amortization
Amortization has the same meaning as depreciation, with the exception that the latter is used on intangible assets and not tangible assets. The main objective is to match the cost of the asset with the advantages it creates within a time frame.
Illustration: If an organisation buys software for ₹10,00,000 with a life of 5 years, the expenditure needs to be spread equally or proportionately in the years according to the anticipated benefit pattern.
Formula for Amortization
In India, the widely applied method (approach) to determine amortization is the straight-line method (SLM).
{Annual Amortization Expense} is equal to {Cost of Asset} minus {Residual Value} divided by {Useful Life (in years)}
The asset value is determined by adding the purchase and any direct costs. Residual value is the estimated value at the end of a product’s economic life, typically set to zero for intangible assets. Useful life is the time during which an item should render benefits.
Calculation Example
Let us assume a company acquires a patent for ₹12,00,000 on April 1, 2023. Useful life: 6 years Residual value: ₹0 Amortisation method: Straight-line
Computation: {Annual Amortisation} = {12,000,000 – 0}.{6} provides us with ₹2,00,000 {per annum}.
The firm would credit ₹2,00,000 in its Profit & Loss account annually for six years.
If the patent is utilized for six months (i.e., 9 months), then the expense is distributed proportionately: 2,00,000 multiplied by {9/12} = ₹1,50,000.
Methods of Amortisation
Although the most common is the Straight-Line Method (SLM), other methods can be utilised if they better reflect the pattern of utilization of the asset:
- The Straight-Line Method (SLM) assumes equal yearly expenses.
- The Reducing Balance Method: Has greater expenses in previous years.
- The Unit of Production Method: Costs are calculated using actual utilisation or output.
As per AS 26, the selected method should indicate how economic advantages are used.
Useful Life and Residual Value
- The useful life of an asset is estimated on a legal, contractual, or economic basis.
- AS 26 recommends a maximum usable life of 10 years if it is not possible to have a reliable estimate.
- Intangible assets do not usually possess a residual value, apart from licenses that may be resold.
Disclosure Requirements
- AS 26 and the Companies Act, 2013 (Schedule II) specify the amortisation basis used.
- Useful life or rate used.
- Compute the gross carrying amount and accrued amortisation at the beginning and end of the period.
- Any change in the estimated useful life or basis should be disclosed and accounted for beforehand.
Amortisation under the Income Tax Act, 1961
Under Section 32(1)(ii) of the Income Tax Act 1961, intangible assets like goodwill, trademarks, licenses, and patents are eligible for 25% depreciation using the Written Down Value (WDV) method. Hence, whereas accounts normally follow AS 26 (SLM), tax calculations apply the WDV method to compute eligible deductions.
Amortisation is an important accounting device that prevents intangible assets from being overvalued in financial statements and their expense from being reasonably matched with earnings. Adhering to AS 26 guidelines and the Companies Act, 2013, Indian businesses provide accuracy, consistency, and transparency to financial reporting.
Is Amortisation a Liability or Expense?
Amortisation is classified as an expense, not a liability. It is the term used for the systematic apportionment of the cost of an intangible asset (such as patents, goodwill, or trademarks) over its useful life. Some part of the value of the asset is charged to expense every year in the Profit & Loss Account to provide for its consumption or degradation.
This expense is a non-cash expense, in the sense that it does not involve a cash outflow but allows matching of the expenses with the revenues generated by the asset.
Although the cost of amortisation appears on the income statement, the cumulative amortisation is subtracted from the asset on the balance sheet and thus reduces its book value.
Impact of Amortisation on Taxable Income
Amortisation decreases taxable income since it is treated as a deductible expense under the Income Tax Act, 1961. Businesses can deduct a share of the expenses pertaining to intangible assets, such as goodwill, trademarks, patents, or licenses, for many years. The deduction reduces the company’s net profit before taxation, thus lowering the overall income tax to be paid.
As per Section 32(1)(ii) of the Income Tax Act, 1961, eligible intangible assets can be depreciated at 25% by the Written Down Value (WDV) method. The amortisation under accounting principles (e.g., AS 26) can differ from the tax-allowed depreciation, resulting in temporary differences and deferred tax adjustments.
Finally, amortisation allows companies to lawfully reduce their taxable income while maximizing cash flow and synchronising tax burden with the economic use of the asset.
Conclusion
Amortisation is a basic accounting practice that ensures the fair and uniform allocation of the cost of intangible assets throughout their useful lives. It depicts the cumulative depletion, expiration, or depreciation of assets like goodwill, trademarks, patents, and software, matching their costs with the revenues they generate. Firms that report amortisation as an expense hold accurate profit assessments and avoid inflating asset values.
In addition, amortisation increases financial statement accuracy and credibility through the application of the matching principle and accrual basis of accounting. Amortisation in India is governed by Accounting Standard (AS) 26 or Ind AS 38, which offers a systematic method of expense recognition. Ultimately, it contributes to presenting an accurate and fair representation of the company’s financial condition, ensuring that intangible assets are valued and utilised responsibly over time.
