Terms Beginning With 'a'

Amortisation

What is Amortisation of Intangibles?

Amortisation of an asset refers to an accounting process of spreading cost of an intangible asset over its useful life. Amortisation is applied alongside Depreciation to expense the cost of capital investments made in assets that are capitalised on balance sheet.

Similar to Depreciation, it allows businesses to lower the tax liability since it is recorded on income statement as an expense. Intangible assets are recognised when cost of the asset is measurable, and future economic benefits are likely.

A business should be able to measure cost of intangible asset to capitalise on balance sheet. Despite no physical substance, it should have legal rights over the asset and ability to transfer ownership. Intangible assets are expected to generate future economic benefits for an enterprise.

Future economic benefits such as an expected increase in operating revenue of the company. Consider ABC Ltd has a five-year license to export specific goods in Japan, therefore ABC Ltd can generate sales through the license.  

But sometimes firms can develop intangible assets internally. Generally, it is research and development. Firms cannot capitalise expenses of a potential asset during the research, and expenses are recorded in income statement. During the development phase, firms can capitalise the expenses after:

Internally generated goodwill is never capitalised, and goodwill can only be recognised during a business combination. Firms may generate intangible assets internally, but they should be able to measure cost to capitalise it.

How are intangible assets measured?

An enterprise can separately purchase an intangible asset, which is recorded at cost. Internally generated assets should be able to meet above criteria (image), and others are mostly measured at fair value.

Cost of the asset includes the purchase price of the asset including any non-refundable expenses and excluding discounts. It also includes directly attributable expenses such as delivery and handling costs, installation costs, consulting fee etc.

Costs will be capitalised when firms acquire asset or internally generate an asset through above criteria (image). A firm is also required to measure the asset in subsequent periods. Cost and revaluation models are applied to measure intangible in subsequent periods.

In cost model, the asset is recorded at cost less accumulated amortisation and any impairment loss. In revaluation model, the asset is recorded at fair value minus accumulated amortisation and any impairment loss. Revaluation model is used when the firm can measure the fair value of the asset, which can only be measured in case of an active market for the asset.

How are intangibles assets amortised?

Intangible assets are amortised over the useful life. The amount of amortisation allocated to each year is the cost of the asset less residual value. It is important to have a useful life for the asset to allocate amortisation expense each year.

After arriving at the useful life of the asset, firms may use any method of amortising an asset like the straight-line method, accelerated method or units of production method.

The expected life of the asset can be estimated by assessing the longevity of the asset to produce gains for the firm. Businesses are also required to test the useful life of the asset each year since developments in the ecosystem could impact the life of the asset. For instance, a significant deterioration of a brand’s market share.  

What about indefinite life of intangible assets?

Firms do not amortise assets that have an indefinite life, which are tested for impairments each year, and impairments are charged over the asset when required. In the event of sale of an intangible asset, it can be derecognised. Firms can also derecognise intangible asset when future economic benefits are not viable.

Amortisation of goodwill – the debate continues

IAS 38 says that internally generated goodwill should not be recognised as an asset since it is not identifiable and measurable. But goodwill arising due to business combinations is recognised and capitalised under IFRS 3 Business Combinations.

IFRS 3 roughly says that goodwill is measured as the difference between consideration of the business and fair value of separable net assets acquired during the transaction. Just like intangibles with an indefinite life are tested annually for any potential impairments, purchased goodwill is also subject to annual impairment testing.

Stakeholders and investors have been critical of the annual impairment approach used by corporations to evaluate accumulated goodwill. They noted that businesses are recognising impairment losses ‘too little, too late’.

Consider a distressed business is acquired by a high performing business, the subsequent impairment test will be conducted on the combined entity, resulting in higher levels of internally generated goodwill.

Although internally generated goodwill is not recognised in the balance sheet, it creates a premium as a difference between the book value of the net assets of combined entity compared to market value of combined business. Since combined entity has higher internally generated goodwill, there is no impairment charged, but the combined entity also has a distressed business in its books.

The topic is also getting attention as impairment testing requires significant estimates and judgements that includes measurement of future cash flows. Management can also influence the timing and scale of impairment.

In 2004, the impairment approach to goodwill valuation was introduced. Before that, goodwill used to be amortised, assuming that life is not more than 20 years. It was also required to test goodwill for impairment purpose under certain circumstances.

Proponents of amortisation of goodwill say that using amortisation allows to avoid complexities involved in impairment testing and provide a steady decline in the recorded value of goodwill. Likewise, a steady charge to goodwill would alleviate the fluctuations of reported profits.

The International Accounting Standards Board is conducting 2020 agenda consultation, and responses are welcomed by the body until 31 December 2020.  

Earnings Before Interest Taxes and Amortisation (or EBITA) is an operating performance measure of a company, which assist investors in comparing companies stripped of their capital allocation decisions, post considering the depreciation into account.

Earnings Before Interest, Depreciation and Amortisation (or EBIDA) reflects the earnings of a company post adding the interest expense, depreciation & amortisation to the net income, and taking tax into consideration.

What is EBITDA? Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) is a widely used financial metric in evaluating cash flows and profitability of a business. Market participants closely track EBITDA and apply it in decision making extensively. Although conventional investors like Charlie Munger had raised concerns over the use of EBITDA, it is very popular in markets, and M&A transactions are mostly priced on EBITDA-based valuation like EV/EBITDA (x). EBITDA is not recognised by IFRS and GAAP but is used extensively in the Corporate Finance world. It is now a mainstream financial metric that companies look to target. EBITDA depicts operational cash generation capacity of a firm in a given period. It acts as an alternative to financial metrics like revenue, profit or earnings per share. EBITDA allows to evaluate a business operationally and outcomes of operating decisions. Non-operating items are excluded to arrive at EBITDA. EBITDA excludes the impact of capital structure or debt/equity, and non-cash expenses like depreciation and amortisation. A particular criticism of EBITDA has been the inappropriate outlook of capital intensive businesses, which incur large depreciation expenses. Business with large assets incurs substantial costs related to repair and maintenance, which are not captured in EBITDA because depreciation expenses are accounted to calculate EBITDA. Meanwhile, EBITDA can paint an appropriate picture for asset-light business with lower capital intensity. While revenue, profit and earning per share remain sought-after headline generators for corporates, EBITDA has also found its growing application in the corporate finance world and is now a mainstream metric to evaluate a business financially. Perhaps the growth of asset-light business models has also added to the use of EBITDA. Its debt-agnostic approach to evaluate businesses has given reasons to investors, especially for high growth firms during capital expenditure cycles. But EBITDA has been present for close to four decades now. In the 1980s, the growth in corporate takeovers through leverage buyout transaction was on a boom. EBITDA grew popular to value heavy industries like broadcasting, telecommunication, utilities. John Malone is credited for coining this term. He was working at TCI- a cable TV provider. Since EBITDA has remained an important metric to determine purchase price multiples and is highly used in M&A transactions. EBITDA’s application in large businesses with capital intensive assets that are written down over a long period has been a source of concern for many investors. Although EBITDA is an effective metric to evaluate the profitability of a firm, it does not reflect actual cash flow picture of a firm during a period. Also, it does not account for capital expenditures of the firm, which are crucial in successfully running a business. EBITDA does not give a fair cash flow position because it leaves out crucial items like working capital, debt and interest repayments, fixed expenses, capital expenditure. At the outset, there can be times when EBITDA may overstate performance, value and ability to repay debt. How to calculate EBITDA? NPAT: Net Profit after tax is the amount reported by a firm in the given period. It is present on the income statement of the firm and is used in the calculation of earnings per share of an entity. To calculate EBITDA, interest expense, tax, depreciation and amortisation are added to NPAT. Interest Expense: Firms can employ debt in their capital structure, and interest expense is funds paid to lenders as interest costs on principal debt. Most companies have different financing structure, and excluding interest payments enable comparing firms on operating grounds through EBITDA. Tax: Firms also pay income tax on profits. Excluding taxes gives a fair picture of the operating performance of the business since tax vary across jurisdictions, and sometimes according to size of business as well. Depreciation: Depreciation is the non-cash expense to account for the steady reduction in value of tangible assets. Firms can incur depreciation expense on machinery, vehicles, office assets, equipment etc.  Amortisation: Amortisation is the non-cash expense to account for the reduction in the value of intangible assets like patents, copyrights, export license, import license etc. Operating Profit: Operating profit is the core profit of a firm generated out of operations. It includes cash and non-cash expenses of a firm, excluding income tax and interest expenses. Operating Profit is also called Earnings Before Interest and Tax (EBIT). Read: EBIT vs EBITDA What is TTM EBITDA and NTM EBITDA? Trailing Twelve Months (TTM) or Last Twelve Months (LTM) EBITDA represents the EBITDA of the past twelve months of the firm. It allows to review the last operation performance of the business. Whereas NTM EBITDA represents 12-month forward forecast EBITDA of the firm. NTM EBITDA is also one-year forward EBITDA. Market participants are provided with consensus analysts’ estimates for a firm, which also include NTM EBITDA, NTM EPS, NTM Net Income or NPAT. What is EBITDA margin? EBITDA margin is the percentage proportion of a firm EBITDA against total revenue. It indicates the operational profitability of the firm and cash flows to some extent. If a firm has a higher margin, it means the level of EBITDA against revenue is higher. It is widely used in comparing similar companies and enable to evaluate businesses relatively. If a firm has a total revenue of $1 million and EBITDA is $800k, the EBITDA margin is 80%. What is adjusted EBITDA? Adjusted EBITDA is calculated to provide a fair view business after adding back non-cash items, one-time expenses, unrealised gains and losses, share-based payments, goodwill impairments, asset write-downs etc.

What is depreciation? Depreciation is an accounting method used to allocate the cost of a tangible asset to the books of accounts over the useful life of the asset. It is essentially the accounting for wear and tear on the asset over its useful life.  Depreciation also refers to the value of the asset that has been used over time. Assets of a firm that are used for over a one-year period largely include physical assets. Although firms incur expense while purchasing these assets, the expenses are not charged in the income statement.  Such assets are recorded in the balance sheet of the firm and are expensed on the income statement as depreciation expense over time during the life of the asset. The tax authorities also decide the useful life of assets because overstating depreciation expense can lower tax liability.  Now assets come in two variety: tangible assets and intangible assets. As the name suggests tangible, the tangible assets can be touched, such as equipment, machinery, computers, vehicles etc. Depreciation is used to expense the tangible assets of a firm.  Intangible assets cannot be touched and include assets like licenses, copyrights, patents, brand names, logos etc. Amortisation of assets is an accounting method similar to depreciation used to expense intangible assets.  Long-term assets are the source of generating revenue for firms over a long period of time, therefore the cost of acquiring tangible long-term assets is not expensed fully at the time of purchases and is expensed over the life of the asset.  As the asset is used over periods, the carrying value of an asset in the balance sheet is reduced over time. Carrying value of an asset is the original cost minus accumulated depreciation on the asset over time.  Since the cost of acquiring the long-term tangible asset is not expensed fully at the time of purchase and is expensed over its useful life, the depreciation expense is a non-cash charge because actual cash outgo was incurred at the time of purchase.  But depreciation expense reduces the reported earnings of the company as it is charged on the income statement of the firm. Since the expenses are deducted from the revenue of the firm, the tax liability of the firm is also reduced.  What are the methods of depreciation? Straight-line method The straight-line method is the most common method of depreciating an asset over its life. Under this method, the recurring depreciating amount of the asset remains constant and is not changed over the life of the asset.  For example, a firm buys a machine for $10000 with a salvage value of $2000, and the useful life of the asset is ten years. The depreciable value of the asset will be $8000, which is the cost of machine minus salvage value.  Now the firm will depreciate the $8000 each year at a rate of $800 per year. The per-year depreciation charge of $800 is the depreciable value of the asset divided by the useful life of the asset (8000/10).  Double declining balance depreciation method  It is an accelerated type of depreciation method. Under this method, the depreciation expense in higher in the beginning years and gradually reduces over the life of an asset. It also reflects that assets are more valuable in the early years of production compared to later years.  In this method, the subsequent depreciation charges after the initial charge are calculated using the ending balance of the asset in the last period. Ending balance of the asset is the original cost of the asset less accumulated depreciation. Also, the depreciation factor in this method is twice of the straight-line method. Depreciation expense = (100%/Useful life of asset) x 2 Why is depreciation due diligence important? Depreciation can be used to manipulate the financials of the company. Overstating and understating depreciation charges directly impacts the profit of the company. When a firm is charging less depreciation than required, it would directly increase the profits of the firm.  When depreciation expense is lesser than the actual expense, the income statement will record lower amount of expenses, therefore the deductions from revenue will lesser and profits will increase.  Investors also assess whether the useful life of asset used in calculating the depreciation of firm is appropriate or not. The companies should use an appropriate useful life of the asset. When the useful life of the asset is increased, the depreciation charges will spread across an increased number of years.  As a result, the depreciation expenses during the life of an asset would be understated since the actual life of an asset is less than recorded. Investors prefer checking the number of years used as the useful life of an asset.  Sometimes firms may choose to change the method of depreciation. Although it could be appropriate when actual business conditions don’t match the method adopted, there remains a possibility that the decision to change the method could be driven by the motive to manipulate depreciation expenses.  Companies may seek to keep the assets in the balance sheet even though the asset is of no use. This will help the company to keep incurring depreciation expense on the income statement and reduce the tax liability of the business.  When the value of assets of the company has appreciated in light of the market environment, the balance sheet value of the asset will also increase. When the balance sheet value of an asset is increased, the depreciation charges should also increase. Therefore, appreciation in the value of an asset should also increase depreciation expense for the company. 

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