Amortisation

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.

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IN A NUTSHELL

    Spreading the cost of intangible assets over time.

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    GLOSSARY DEFINITION

    Amortisation is an accounting technique used to gradually write off the cost of an intangible asset over its useful life. Unlike depreciation, which applies to tangible assets, amortisation is specific to intangibles like patents, copyrights, software, or goodwill. This process allows businesses to spread out the expense of these assets, reflecting their consumption or decline in value over time. Amortisation expense is recognised in the income statement (Profit and Loss Account), reducing net income, and the amortised amount is deducted from the asset’s carrying value on the balance sheet.

    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

    Amortisation is a critical concept in accounting, especially for businesses that invest in intangible assets. It reflects the using up of non-physical assets, ensuring that their cost is accurately matched with the benefits they generate over time. It is the equivalent of Depreciation but for non-physical goods and its treatment is broadly the same.

    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

    Income Statement: Amortisation expense reduces the company’s net income, similar to depreciation. However, it’s specific to intangible assets.

    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.

    In conclusion, depreciation is not just an accounting exercise but a crucial element in strategic planning and financial analysis. For startups and small businesses like an e-bike shop, effective management of depreciation can lead to better financial health and informed decision-making.

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