Amortisation: How It Works, and How It Differs From Depreciation

Amortisation is spreading a cost evenly over time. Applied to an intangible asset, it charges a slice of the purchase price against profit in each year of the asset's useful life. Applied to a loan, it is the schedule by which the principal is repaid over the term. Amortisation differs from depreciation only in what it applies to: intangibles rather than physical assets. The charge itself moves no cash.

Most households have paid once for a big thing and then used it for years. A water purifier, a two-wheeler, a three-year school fee paid up front to get a discount. The money went out in one month. The usefulness came out slowly, month after month, long after the payment was forgotten. A household budget written so that the whole payment sat in one month would make that month look like a disaster and every month afterwards look better than it really was. Neither picture would be true. Amortisation exists because a cost paid once for something used for years is not a cost of the year it was paid. A purchase price and a useful life produce an annual charge, the same word also covers the schedule by which a loan is repaid, and the forecasting mistake this one word causes more than any other comes from reading the charge as a payment.

What is amortisation, and why does the word turn up in two different places?

The word gets used for two things that look unrelated until what they share comes into view. In the first use, a business buys something it will use for years and spreads the purchase price across those years as a yearly charge against profit. In the second use, a borrower repays a loan on a fixed schedule so that the amount borrowed comes down to zero by the end of the term. One is about a cost being recognised. The other is about a debt being repaid. Students reasonably ask why anyone would give both the same name.

The shared idea is in the shape, not the subject. In both uses a single large number is cut into scheduled slices and worked through until nothing is left. A licence bought for Rs 3,00,00,000 with a five-year life becomes five slices of Rs 60,00,000 charged against profit; a loan of Rs 40,00,00,000 repaid over eight years becomes eight slices of Rs 5,00,00,000 repaid to the lender. In each case there is an opening amount, a fixed schedule, and a closing amount of zero. One shape is the whole of what the word means. The rest is detail hanging off that shape.

Sohan Ply and Boards Private Limited, an invented maker of plywood and laminates, works out of a single plant and is written as Sohan Ply throughout. Sohan Ply sells about Rs 1,80,00,00,000 of board a year. Sohan Malhotra runs it and Ritu Chandran is its finance head. Two years ago the business paid Rs 3,00,00,000 for the right to make and sell board under a well-regarded brand name for five years. The licence is an intangible assetSomething a business has paid for and will use for years, but which has no physical substance: a licence, a patent, a purchased brand name, a long software right.: real, paid for, useful, and impossible to touch. The business also carries a term loan of Rs 40,00,00,000 taken against the plant. Both of those show amortisation, and they show it in the two different senses.

How does amortising an intangible actually work?

The arithmetic is identical in a household and the stakes are lower, so take the household version first. Suppose a household pays Rs 12,000 in January for a newspaper delivered all year. Its bank balance falls by Rs 12,000 in January. But the newspaper is worth something in every one of the twelve months, so the honest monthly cost of reading a paper is Rs 1,000, not Rs 12,000 in January and nothing afterwards. Splitting the payment by the months it serves gives a number that can actually be planned with. The split is amortisation, done in a kitchen, without the word.

A business does the same thing with three inputs and one division. The first input is the cost: what was paid. The second input is the useful lifeThe number of years the business expects to get benefit from the asset. For a licence it is usually the period the licence runs for; for a machine it is an estimate of working years., how long the thing will be useful. The third input is the method that decides the shape of the slices. The simplest and most common method is straight-lineDividing the cost by the number of years so every year takes an identical slice. The alternative shapes, which load more cost into the early years, are covered under financial accounting.: divide the cost by the life and charge the same amount every year. Cost divided by useful life gives the annual charge, and for Sohan Ply's licence that is Rs 3,00,00,000 divided by five years, or Rs 60,00,000 a year.

The division does something to the profit line worth pausing on. In each of five years, Sohan Ply's profit is Rs 60,00,000 lower than it would have been if the licence had never been bought. The five charges add to Rs 3,00,00,000, exactly what was paid. Nothing is created and nothing is hidden; the same money is simply recognised in the years that receive the benefit rather than the year in which the cheque was written. The table below runs the whole five years.

How is it different from depreciation?

Here is the answer most people are looking for, and it is smaller than they expect. DepreciationThe same spreading of a cost over a useful life, applied to a physical asset such as a machine, a building or a vehicle. The word changes, the arithmetic does not. is the identical mechanism applied to something physical. A press, a forklift, a boiler, a building: each is bought once, used for years, and charged against profit in slices. Amortisation is that mechanism applied to something that cannot be touched. The arithmetic, the schedule and the effect on profit are the same; only the kind of asset is different, and the accounting vocabulary follows the asset rather than the method.

An everyday pair makes it stick. A driver buys an autorickshaw for Rs 3,00,000 and pays a fee for the permit that allows it to be run commercially. The vehicle wears out, so its cost is depreciated. The permit does not wear out in any physical sense, but it runs out, so its cost is amortised. Both are spread over the years they serve. Asked which cost was real, the driver would honestly answer both, and neither is felt in the months after the payment.

There is one distinction worth carrying. A physical asset usually has something left at the end: a worn machine sells for scrap, a building stands. A licence with a fixed term usually has nothing left at the end; the right simply expires and the last slice takes the balance to zero. Intangible lives are therefore often just the length of the contract. Physical lives are estimates that reasonable people argue about. Sohan Ply's licence has five years written into it, so its life is not a matter of judgement at all.

Why is it a cost that moves no cash?

The payment and the charge fall in different years, and that split changes how every set of accounts is read. Sohan Ply's profit line this year shows a charge of Rs 60,00,000 for the licence. The plainest possible question is how much money left the bank this year because of that charge. The answer is nothing. Not a rupee. The money left two years ago, in one payment of Rs 3,00,00,000, and the bank account has been untouched by the licence ever since. The profit line now carries a memory of a payment, not a payment.

A cost that lands on the profit line while the bank sits untouched is a non-cash chargeA cost that reduces reported profit in a period without any money moving in that period. Depreciation and amortisation are the two met most often.. The cash reduction already happened, in full, in an earlier year, so amortisation reduces profit without reducing cash. Every household knows the feeling even without the vocabulary. A wedding hall is booked in March and paid for in March; the wedding is in December. The payment is nine months in the past, so December carries a large cost and no payment. Anyone budgeting December's money by looking at December's costs would get a badly wrong answer in both directions.

Put Sohan Ply's numbers on it. Operating profit before depreciation and amortisation is Rs 21,00,00,000 for the year. Depreciation and amortisation together take Rs 4,00,00,000 of that, of which Rs 3,40,00,000 is depreciation on the plant and Rs 60,00,000 is the licence. Interest takes another Rs 4,50,00,000. Profit before tax comes to Rs 12,50,00,000. Of the Rs 8,50,00,000 that separates the top figure from the bottom one, the Rs 4,50,00,000 of interest genuinely left the bank this year and the Rs 4,00,00,000 of depreciation and amortisation did not. Two costs, both real, only one of them a payment.

What is left on the balance sheet while the charge runs?

Every year the charge takes a slice out of profit, something must be taking a slice out of somewhere else, and that somewhere else is the balance sheet. The business had swapped cash for a right of equal recorded worth, so the licence went onto the balance sheet at Rs 3,00,00,000 when it was bought. Each year's Rs 60,00,000 charge does two things at once: it lowers profit, and it lowers the amount at which the licence still sits on the balance sheet. The amount still standing there is the carrying amountThe amount at which an asset still appears on the balance sheet: its cost less everything charged against it so far. Also called its book value or written-down value..

Two opposite movements run together over the five years: the charge climbs from zero to Rs 3,00,00,000 in total, and the carrying amount falls from Rs 3,00,00,000 to zero, and the two always add to the original cost. At the end of year one, Rs 60,00,000 has been charged and Rs 2,40,00,000 is still sitting on the balance sheet. At the end of year three, Rs 1,80,00,000 has been charged and Rs 1,20,00,000 is left. Halfway through year three the two lines cross. At that moment exactly half the cost has been recognised and half is still waiting.

The carrying amount matters for a practical reason. A reader looking at the balance sheet in year four sees the licence at Rs 60,00,000 and might conclude that the business holds a brand right worth Rs 60,00,000. It does not. The right is worth whatever an informed buyer would pay for four more months of it, and that could be far more or far less. The carrying amount records how much of the cost has yet to be charged. The carrying amount is bookkeeping, not valuation, and confusing the two is the mistake that fair value exists to prevent.

How does loan amortisation work, and what is being spread there?

Now the second use, and the thing to hold on to is that it is a different subject wearing the same shape. A household taking a home loan pays a monthly instalment in two parts. One part is rent for the money, called interest. The other reduces the amount still owed, the principalThe amount actually borrowed and still owed, separate from the interest charged for the use of it. Repaying principal reduces the debt; paying interest does not.. Only the second part is amortisation. A loan is described as amortising when its schedule brings the principal down to zero by the end of the term, rather than leaving the whole borrowed amount to be repaid in one lump at the end.

Sohan Ply's term loan of Rs 40,00,00,000 is secured on the plant and runs for eight years, repaying an equal Rs 5,00,00,000 of principal a year. Interest is charged on what is still owed, and what is still owed keeps falling. At an illustrative rate of 9 per cent the first year's interest is Rs 3,60,00,000 and the eighth year's is only Rs 45,00,000. In a loan the principal steps down on a fixed schedule while the interest shrinks with it, so the total payment falls year by year even though the amortisation itself never changes. The instalment structure most households recognise, where the total payment stays level and the split between interest and principal shifts, is a different arrangement of the same idea and is covered under fixed income.

The difference from the intangible case is the one that catches people. Repaying loan principal moves real money out of the bank in every single year. Charging amortisation on a licence moves no money in any year. The word is the same, the shape is the same, and the cash consequence is opposite.

What does Sohan Ply's licence do to profit, and what did it do to cash?

Put the whole thing together on the case, in the words Ritu Chandran would have to use. Two years ago Sohan Ply paid Rs 3,00,00,000 for a five-year brand licence. In that year the bank balance fell by Rs 3,00,00,000 and reported profit fell by Rs 60,00,000. The difference, Rs 2,40,00,000, is not an error and nobody hid anything: it is simply the cost sitting on the balance sheet, waiting for the years it will serve. In the current year, and in each of the two years still to run, profit will take another Rs 60,00,000 and cash will take nothing. At the end of year five the licence will have taken Rs 3,00,00,000 out of profit in total, exactly matching the Rs 3,00,00,000 it took out of the bank once, and it will sit on the balance sheet at zero.

Every misreading of amortisation is a version of forgetting one number: the year-one gap of Rs 2,40,00,000 between what the bank felt and what the profit line showed. This year's profit before tax of Rs 12,50,00,000 would have been Rs 13,10,00,000 without the licence charge. The charge does not touch the Rs 4,00,00,000 of cash the business is sitting on, and it never will.

How do lenders, analysts and buyers actually use this?

Nobody in practice cares about amortisation for its own sake. Lenders and buyers care because amortisation stands between a profit number and a cash number, and both numbers matter. So the first thing a lender does with Sohan Ply's accounts is undo it. Profit before tax of Rs 12,50,00,000, plus the Rs 4,00,00,000 of depreciation and amortisation that never moved, plus the Rs 4,50,00,000 of interest, added back so that the money available before the lender's own claim is visible, comes back to EBITDAEarnings before interest, tax, depreciation and amortisation. A rough measure of the cash a business generates from trading, before the cost of its funding and before spending on assets. of Rs 21,00,00,000. Earnings before interest, tax, depreciation and amortisation sit closer to the cash that can service a debt, and the loan covenant will be written against that figure.

But the add-back is only half the job, and the half that gets forgotten is the expensive one. Adding back amortisation says the licence cost no cash this year; it does not say the business never has to buy anything again. Sohan Ply spends Rs 5,50,00,000 a year on plant and equipment, and its working capital grew by Rs 2,00,00,000 this year. Take those off the Rs 21,00,00,000 and the simplified free cash flow before tax is Rs 13,50,00,000. A lender who added back the Rs 4,00,00,000 and stopped there would be looking at a business that seems to throw off Rs 21,00,00,000 of spare money a year, and would be wrong by a wide margin.

Deodar Growth Partners, the invented investor negotiating for 20 per cent of the business, runs the same arithmetic for a different reason. Deodar is trying to price what it will actually receive, and no investor receives amortisation. A household deciding whether a shop is worth buying does exactly this without the words: it asks what the shop takes in, what it must spend to keep the shutters open, and what is left over in cash at the end of the month. The accounting charge for something bought three years ago has no place in that sum, and neither the lender nor the buyer will let it stay there.

Sohan Ply and Boards Private Limited, Sohan Malhotra, Ritu Chandran and Deodar Growth Partners are invented.
Educational material. Not advice on any investment, tax, budget or market position.