What Is Amortisation? Definition and Examples

Amortisation is an accounting technique that systematically reduces the recorded cost of an asset or a loan over a specific period. This method spreads out a large expenditure or debt repayment, rather than recognizing the entire amount at once. It aligns the expense of using an asset or repaying a loan with the periods in which it generates economic benefits, accurately reflecting an asset’s declining value or a loan’s decreasing principal balance over time.

Amortising Intangible Assets

Amortisation applies to intangible assets, which are non-physical assets possessing long-term value for a business. Examples include patents, copyrights, trademarks, software licenses, and customer lists. These assets are amortised to match their cost with the revenue they help generate throughout their useful life.

The most common method for calculating amortisation for intangible assets is the straight-line method, which divides the asset’s initial cost by its estimated useful life. For example, a software license costing $10,000 with a five-year useful life would have an annual amortisation expense of $2,000. Intangible assets are generally considered to have zero residual value at the end of their useful life for amortization calculations.

Amortisation impacts financial statements by appearing as an expense on the income statement, reducing reported net income and taxable income. On the balance sheet, the asset’s carrying value is reduced by accumulated amortisation, a contra-asset account. For U.S. federal income tax purposes, many acquired intangible assets, including goodwill, are classified as Section 197 intangibles and must be amortised over 15 years using the straight-line method, regardless of their actual useful life. This amortisation begins in the month of acquisition, allowing businesses to claim annual tax deductions.

Amortising Loans

Amortisation is also widely used for loans and debt repayment. An amortised loan is structured with regular payments, each comprising both principal and interest, eventually reducing the outstanding loan balance to zero by the end of the loan term. Common examples include mortgages, car loans, and personal loans.

The amortisation schedule details how the proportion of interest versus principal changes over a loan’s life. In the early stages, a larger portion of each payment is allocated to interest because the outstanding principal balance is higher. As payments are made and the principal balance decreases, the interest portion of subsequent payments shrinks, and a greater portion goes towards reducing the principal.

For instance, on a $300,000 mortgage with a 5% interest rate paid over 30 years, initial monthly payments of $1,610.46 would see a significant portion go to interest, such as $1,250 in the first month. As the loan progresses, the principal portion of the payment steadily increases while the interest portion declines. This inverse relationship between interest and principal within fixed payments is a defining characteristic of loan amortisation. Borrowers can make extra payments to reduce the principal balance, which can shorten the loan term and save on total interest paid over time, although the required minimum monthly payment amount typically remains unchanged.

Amortisation Versus Similar Concepts

Amortisation is distinct from similar accounting concepts like depreciation and depletion. While all three methods spread costs over time to match expenses with revenues, they apply to different types of assets and account for different forms of value reduction.

Depreciation is the accounting method used to expense the cost of tangible assets over their useful lives. Tangible assets are physical items such as buildings, machinery, vehicles, and office equipment. Depreciation accounts for physical wear and tear, obsolescence, or consumption of these assets over time. Several methods can calculate depreciation, including the straight-line, declining balance, and units-of-production methods, which allocate the asset’s cost based on time or usage.

Depletion, in contrast, is the accounting method used to allocate the cost of natural resources as they are extracted or consumed. Natural resources include items like oil, gas, timber, and mineral deposits. Depletion recognizes that physical removal of these resources reduces available reserves. It is typically calculated based on the units of resource extracted, with the cost per unit determined by dividing total capitalized costs (acquisition, exploration, and development) by the estimated total recoverable units. This allows companies to expense the resource’s cost as it is used up, aligning the expense with the revenue generated from its sale.