Our Context
To make our practical finance section as useful and practical as possible, all the definitions and insight will be in the context of a E-Bikes shop that we call E-Zee Bikes. This gives you a more hand ons view and more relatable to what the numbers actually mean.
IN A NUTSHELL
Spreading the cost of intangible assets over time.
GLOSSARY DEFINITION
WORKED EXAMPLE
Suppose our e-bike shop develops a proprietary software system for inventory management, costing £20,000, with a useful life of 5 years and no salvage value.
Using straight-line amortisation, the annual amortisation expense would be:
Annual Amortisation=Useful Life Cost of the Intangible Asset
Annual Amortisation is £20,000 over 5 years so 20,000/5 =£4,000
Each year, £4,000 is recognised as an amortisation expense.
USED IN A PHRASE
“Our new software’s amortisation impacts our financial statements for five years!”
DETAILED MEANING
Types of amortisation
Straight-Line Amortisation: Similar to straight-line depreciation, this method evenly distributes the cost of an intangible asset over its estimated useful life. It’s commonly used due to its simplicity.
Accelerated Amortisation: This method applies a higher amortization charge in the early years, decreasing over time.
Unit of Production Amortisation: Less common, this method bases amortization on the usage or output of the intangible asset.
Implications of Financial Statements
Balance Sheet: The intangible asset’s book value decreases annually by the amortization amount. This reduction continues until the asset is fully amortised or reaches its residual value.
Cash Flow Statement: Amortisation, being a non-cash expense, is added back to net income in the cash flow from operating activities.
Strategic Considerations
Tax Planning: Amortisation can reduce taxable income, providing a tax shield, especially important for startups or small businesses.
Investment and Budgeting: Understanding amortization is crucial for evaluating the cost-benefit of intangible asset investments and for accurate budgeting.
Financial Reporting and Analysis: Properly accounting for amortization ensures compliance with accounting standards and provides a clearer picture of the company’s financial health.