Amortisation is an important concept, whether you’re looking at your household finances or the financials of a large corporation in which you’re considering an investment. Understanding amortisation and how it works can help you better understand the long-term picture of either one.
What is amortisation?
Amortisation is an accounting term that actually has two very different and distinct uses. In financial accounting, amortisation is the practice of spreading the cost of an intangible asset over its useful life — things like patents, franchise agreements, costs of issuing bonds, and so forth. If the useful life of a patent is five years and the cost of it is £100,000, then you’d be able to expense it across five years at £20,000 per year. It would appear under the expenses section of a financial statement.
In a lending context, which you may also encounter as an investor in real estate investment trusts or mortgage-based investments, amortisation is a technique by which loan financing is configured. An amortised loan typically front-loads the interest so that borrowers are paying the most interest with the first payment and subsequently pay an increasing amount of principal (and decreasing amount of interest) as the loan matures. Like amortisation for accounting, the value of an asset decreases over time, but in this case, it’s a loan.
Amortisation of intangible assets
Intangible assets can be an important part of a company’s portfolio, depending on what the company does. For example, a pharmaceutical company heavily invested in research and development would have many intangible assets that would be on a short clock since drug patents only last 20 years from the filing date. It’s vital that a company properly amortise these intangibles when reporting its yearly or quarterly financials so that investors can understand how the company is doing.
As with depreciation, a similar concept for tangible assets, amortisation helps reduce the amount of taxable income the company produces. A few things that can be amortised include goodwill, patents, copyrights, trademarks, and branding. Basically, intangible assets that can be amortised include anything that is important to the running of the business but can’t be touched or held, making them sometimes difficult to both define and value.
Amortisation of loans
Amortisation schedules and amortisation of loans, on the other hand, refer to how a loan is paid down over time. Like with the amortisation of intangible assets, the value of a thing — in this case, your loan — decreases over time. But unlike with the amortisation of intangible assets, you can’t use this as a write-off. You theoretically gain free equity with each payment, which is almost the opposite of the amortisation of intangible assets, where the remaining value is lost with each passing term.
In the amortisation of loans, you’ll generally have a fixed payment, with interest and principal payments that change over time. With mortgage loans, interest is front-loaded so that each payment is equal. Otherwise, you’d have various-sized payments, with very high payments in the beginning as the interest would be higher on the larger principal and decreasing payments over time. Instead, they’re calculated using a constant payment method that allows you to gain equity more quickly without having to actually make a bigger payment at any point.
However, not all mortgages or loans fully amortise, meaning that the final payment doesn’t represent your having paid the entire amount due. In these cases, there will be a balloon payment due (a large lump sum payment). A partially amortising loan can be A nightmare for homeowners or companies that are unprepared.
Negatively amortising loans are far worse, though. These loans allow you to pay less than the accruing interest. The balance grows over time so that you owe as much or more than you borrowed at the end.
Amortisation and investing
Both kinds of amortisation are important for investors. Depending on what you’re investing in, you may need to understand the declining value of intangible assets or the way that many loans are structured.
Going back to the example of the pharmaceutical company you’re considering investing in, if you see that it’s writing down a lot of income because of the value of its ageing intangible assets, it’s important to look into what these assets actually are. They won’t likely appear as line items, so you’ll have to do some digging to make sure that the company isn’t resting on its laurels or over-inflating the value of its intellectual property.
If you’re a real estate or REIT investor, knowing that loans typically don’t start paying off much of the principal on real estate right away may help you better understand the strategy of a REIT.
For example, if a residential REIT just made a large acquisition using a loan, it knows that it can’t further leverage that property right away. It needs to pay down a great deal of interest before it can access significant principal without putting too much equity at risk. This knowledge is also helpful when evaluating mortgage REITs since you’ll be aware that new loans will pay the most interest in the first several years.
Amortisation vs depreciation
Depreciation and amortisation are both methods for spreading out the cost of assets over their useful life, but they differ in what kind of assets they apply to. Depreciation tackles tangible assets like buildings or machinery that wear out over time, reflecting their declining value. Amortisation, on the other hand, is for intangible assets like patents or copyrights that have a limited lifespan but don’t physically deteriorate – it allocates their cost over the period they benefit the company.
Key Differences
| Amortisation | Depreciation |
| Applies to intangible assets. | Applies to tangible assets. |
| Spreads an asset’s cost on paper. | Reduces the value of an asset on paper. |
| Typically applied using the straight-line method. The amortisation charge is the same each year across the period. | There are multiple methods a business can use, including Straight-Line, Declining Balance, Double-Declining Balance, Sum-of-the-Years Digits, and Units of Production. |
| Does not consider the salvage value of the asset being amortised. | May consider the salvage value of the asset being depreciated. |
| May not use contra assets | Always uses contra assets. |
What is depletion?
Beyond amortisation and depreciation, there is a third alternative that’s sometimes used called depletion. This is typically deployed when a business is using up some form of natural resource.
For example, mining sites only have so many metals to extract, and it’s a similar story with oil wells. As such, the set-up cost of these extraction facilities can be spread out over the life of the mining site.
Typically, depletion is communicated using one of two methods:
- Percentage depletion – the business assigns a fixed percentage of depletion to the gross income generated from the extraction site.
- Cost depletion – the business takes into consideration the cost basis of the facility, its salvage value, and number of units sold by the facility.
Impact on cash flow
Amortisation, depreciation, and depletion all appear on the income statement as an expense. And subsequently, a firm’s net income will be reduced by the amount of these costs. However, it’s important to remember that amortisation, depreciation, and depletion only exist as an expense on paper. None of these line items actually impact a firm’s cash flow.
Consequently, this can make businesses appear less profitable than they actually are. Investors need to take this into consideration when analysing a firm’s financial statements to arrive at more accurate conclusions.