Motley Fool's Mike King on CLH, page-20

@antman - amortization for purchsed debt ledgers (given they must tend to zero at the end of their life) in simple terms is the rate at which the purchase price for the debt comes off the balance sheet and is included in the Income Statement. Actually calculating it properly as required is a bit more involved and have explained a bit more below.

CLH's accounting policy is amortised cost. Simply put they will book an asset when they buy a parcel of debt at the value they paid (this would be the fair value of the debt they buy given the transaction is between two unrelated parties). As this amount is on the balance sheet, over time it must reduce and be included in the Income Statement. Amortised cost requires the use of the effective interest rate method. This method effectively gives the amortisation rate. Technically speaking the revenue in the income statement for amortised cost would be interest revenue plus/minus gains/losses on re-estimating future cash flows expected to be received. But for these sorts of assets it can be done via calculating the movement in the carrying amount of debt between perdiods and thus the amortisation and then subtracting this from the cash received as it arrives at the same answer and provides useful information.

The first step in amortised cost requires the determination of the effective interest rate. This is the discount rate at inception that exactly discounts the future expected cash flows over the life of the asset. Given the asset must tend to zero (once repaid/retired or it is statute barred) then the effective interest rate can be determined by estimating the future collections (amount and their timing) and then discounting these so the result equals the purchase price. This will give the effective interest rate. A simple example as follows:



In this case the price paid is $0.2 (let's say for a dollar of debt, so pay 20cents in the dollar). The estimated cash receipts total 0.43 cents and their timing is as shown above - note these are estimates as the customer owes $1, but on average not all of this is expected to be received given the nature of the asset, this estimate is obviously quite subjective, but modeling can help. This gives a return over the life of 43 cents for an investment of 20 cents or a multiple of 2.15 times. The discount rate that exactly discounts these cash flows (43 cents) to the purchase price (20 cents) is 45%. This is the effective interest rate.

So in period one the discount would unwind and this gives "interest revenue". Thus 20 cents multiplied by 45% gives 9 cents. If period one actual cash receipts equaled the estimate and the estimated future cash receipts didn't change then this would be the amount of revenue received. As 14 cents cash was actually received and revenue was 9 cents, then the asset value must have reduced by 5 cents. This would be the amortization in year one.

Now the cash received is highly unlikely to equal the estimate, given they are estimates, and the future cash flows estimates should change where estimates change, which given new information would be known (e.g. how the parcel of debt is performing etc.) is also highly likely. The adjustments for these items are effectively dealt with via the amortised cost model. Let's assume that only 13 cents was actually received in period one, rather than the 14 initially estimated and period 2 cash flows are also now expected to be 10 cents (not 12 cents). All the other future cash flows estimates haven't changed. Also note the effective interest rate is still 45% as this doesn't change. The following table shows the revised future estimated cash flows discounted at the original 45% (note the exact number, which my example uses is just under 45%, but not showing the decimal places). Notice the time period has reduced by one for each as we are now one year in the future.





The above shows a revised discounted number at the end of period 1 (note cash flows in period one have already occurred so are removed) of 13.7 cents. From the 0.2 cents booked initially this is a reduction of 6.3 cents. Thus amortization for period one would actually be 6.3 cents (greater than the estimate of 5 cents initially). Cash received was 13 cents, so revenue for year one in this revised scenario is actually 6.7 cents. This is a reduction in revenue of 2.3 cents from the initial projection. This results from a combination of $1 less received in year 1 than expected and a reduction in the future cash flow estimate for year 2 of $2 (which is yet to happen). The reason the reduction is 2.3 cents and not 3cents is down to the effects of time value of money or discounting.

This goes on until the debt (portfolio or parcels) is either repaid or it becomes statute barred (i.e. no longer collectible). At this point there will be zero cash flows expected in the future and the value of the debt must be nil so the full purchase price has been amortised to the earnings statement (within revenue). It is also worth noting that the actual cash flows can be greater than the initial estimates. Because the debts are credit impaired at acquisition it would be unreasonable to assume one would collect a dollar for a dollar owed but something less (e.g. the multiple of say 2x). If more is collected then cash flows can increase up to a ceiling of one dollar for every dollar owed plus interest accrued (assuming they also seek to collect that as well).

Hope that helps @antman.