Amortization of Intangible Assets – Calculation, Example and Methods

In business, amortization is the practice of writing down the value of an intangible asset, such as a copyright or patent, over its useful life. Amortization expenses can affect a company’s income statement and balance sheet, as well as its tax liability.

Calculating amortization for accounting purposes is generally straightforward, although it can be tricky to determine which intangible assets to amortize and then calculate their correct amortizable value. For tax purposes, the amortization can result in significant differences between a company’s book income and its taxable income.

Ammortization

Amortization of Intangible Assets

If an intangible asset has a finite useful life, then amortize it over that useful life. The amount to be amortized is its recorded cost, less any residual value. However, intangible assets are usually not considered to have any residual value, so the full amount of the asset is typically amortized. If there is any pattern of economic benefits to be gained from the intangible asset, then adopt an amortization method that approximates that pattern. If not, the customary approach is to amortize it using the straight-line method.

If an intangible asset is subsequently impaired (see below), you will likely have to adjust the amortization level to take into account the reduced carrying amount of the asset, and possibly a reduced useful life.

For example, if the carrying amount of an asset is reduced through impairment recognition from $1,000,000 to $100,000 and its useful life is compressed from 5 years to two years, then the annual rate of amortization would change from $200,000 per year to $50,000 per year.

If the useful life of the asset is instead indefinite, then it cannot be amortized. Instead, periodically evaluate the asset to see if it now has a determinable useful life. If so, begin amortizing it over that period. Alternatively, if the asset continues to have an indefinite useful life, periodically evaluate it to see if its value has become impaired.

Impairment Testing for Intangible Assets

You should test for an impairment loss whenever circumstances indicate that an intangible asset’s carrying amount may not be recoverable, or at least once a year. Examples of such instances are:

  • Significant decrease in the asset’s market price
  • A significant adverse change in the asset’s manner of use
  • A significant adverse change in legal factors or the business climate could affect the asset’s value
  • Excessive costs incurred to acquire or construct the asset
  • Historical and projected operating or cash flow losses associated with the asset
  • The asset is more than 50% likely to be sold or otherwise disposed of significantly before the end of its previously estimated useful life

If there is an impairment of intangible assets, you must recognize an impairment loss. This will be a debit to an impairment loss account and a credit to the intangible assets account.

The net carrying amount of the intangible asset is its former carrying amount, less the impairment loss. This means that you should alter the amortization of that asset to factor in its now-reduced carrying amount. It may also be necessary to adjust the remaining useful life of the asset, based on the information obtained during the testing process.

Steps to Calculate Amortization

  • For calculating amortization under the straight-line method, we need three figures; the cost of an asset, residual value, if any, and its useful life.
  • The cost of an asset is usually the price paid to acquire the asset. If an asset is created in-house, the total cost incurred till the time it is ready to use.
  • Residual value is its scrap value which is normally zero in the case of intangible assets.
  • The useful life of an intangible asset is a period over which an asset is expected to be available for use by an entity.
  • The formula to calculate amortization is (Cost of an asset – Residual value) / Useful life of the asset.
  • After a few years of using the asset, if the company finds out that the intangible asset is no longer useful for the company, it can straight away write off the asset from its books of accounts. The remaining cost of the asset will be booked as an expense in the Income statement, and the value of the asset will be zero.
Amortization of Intangible Assets

Amortization of Intangible Assets Journal Entry

Amortization Calculated as Per the Straight Line Method Is Booked as An Expense Under Income Statement. in The Balance Sheet, the Balance of The Accumulated Amortization Account Will Be Increased Thereby Reducing the Net Cost of The Asset. Popular Course in this category.

Below are the Journal entries booked for amortization of the asset:

DateAccount Title & ExplanationDebit ($)Credit ($)
31-DecAmortization Expense A/c XXX
      To Accumulated Depreciation – Patents XXX
(To book amortization of Intangible assets)
DateAccount title & explanationDebit ($)Credit ($)
31-DecAccumulated Depreciation – Patents XXX
      To Patents A/c XXX
(To book amortization of Intangible assets)

Amortization Methods

General Guidelines

IAS 38 provides general guidelines as to how intangible assets should be amortized:

1. The amortization of an asset should only start when the asset is brought into actual use, and not before, even if the requisite intangible asset has been acquired.

2. The level of amortization should be appropriate so that the book value of an asset is not under or overstated.

The method of amortization used should be commensurate with the use of the asset. If no method is determinable, then the asset must be amortized on a straight-line basis.

Revenue-Based Amortization

In line with the guidelines, revenue-based amortization aims to amortize the intangible in accordance with its contributions to the revenue. It leads to a variable amortization schedule. However, IAS 38 argues against the use of revenue-based methods because it is hard to quantify the contribution of an intangible to revenue. The standard recommends the use of the straight-line method in place of revenue-based amortization.

Indefinite Life Assets

Assets with an indefinite life cannot be amortized in a regular fashion as finite life assets. Instead, every year, a test for impairment is conducted on indefinite life assets. If the asset is found to be impaired, then its useful life is estimated, and it is amortized over the remainder of its useful life like a finite life intangible.

Straight-Line Method

Under the straight-line method (SLM), an asset is amortized to zero or its residual value. The amount of amortization every year is given by:

Amortization = (Book Value – Residual Value) / Useful Life

Uses of Amortization of Intangible Assets

Amortization of intangible assets can be used for two purposes, the first one being for accounting purposes and the second one being for tax deferment purposes.

The amortization methods used for these two purposes are different from each other. When used in the case of tax purposes, the actual lifespan of the assets is not considered, and only the base cost is amortized over a specific number of years.

Intangible assets are not physical in nature, and finding an actual value for them is not as easy as in the case of tangible assets. There are regulations, which group certain assets under the category of intangible assets and give them particular value.

Intangible Assets

Intangible assets are defined as identifiable non-monetary assets that cannot be seen, touched or physically measured, and are created through time and effort. Intangible assets are identified separately on a company’s financial statements, and come in two primary forms: legal intangibles and competitive intangibles.

Legal intangibles are also known as intellectual property and include trade secrets, copyrights, patents, and trademarks. An example would be Coca-Cola’s drink formula which is a closely held trade secret that only a few employees know; this is an example of an internally developed intangible asset.

Useful Lives

Intangible assets have a useful life that is either identifiable or indefinite. Intangible assets with identifiable useful lives are amortized on a straight-line basis over their economic or legal life, whichever is shorter.

Intangible assets with indefinite useful lives are assessed each year for impairment. Impairment losses are determined by subtracting the asset’s market value from the asset’s book/carrying value. If an impairment loss is found it is recognized on the income statement and the intangible asset value is reduced.

Under US GAAP, intangible assets are classified into: Purchased vs. Internally Created Intangibles, and Limited-Life vs. Indefinite-Life Intangibles.

Financial Statement Recognition

Firms initially record intangible assets at cost, however only costs associated with the outright purchase in the acquisition of an intangible asset.

Research and development costs incurred during the internal development or self-creation of an intangible asset are not costs that can be capitalized. This then means that some companies have very valuable assets that they are not allowed to recognize on their balance sheets under US GAAP.

Valuation of Intangible Assets

Valuation models can be used to value intangible assets such as patents, copyrights, software, trade secrets, and customer relationships. Since few sales of intangible assets are observable, benchmarking the value of intangible assets can be difficult. As a result, present value models or estimating of the cost to recreate an intangible asset are often used to is these valuations.

Although they have no physical characteristics, intangible assets have value because of the advantages or exclusive privileges they provide to a business.

Intangible assets generally arise from two sources:

  • (1) exclusive privileges granted by governmental authority or by legal contracts, such as patents, copyrights, franchises, trademarks, and trade names; and
  • (2) superior entrepreneurial capacity or management know-how and customer loyalty, which is called goodwill.

The valuation of intangible assets with identifiable useful lives such as patents, trademarks, and copyrights are initially valued at acquisition costs. The value of these assets can be increased or decreased, based on the outcomes of court proceedings.

If a company incurs legal costs to successfully defend an intangible asset, those costs are capitalized and increase the value of the intangible. On the other hand, if a company is unsuccessful in defending an intangible asset, the intangible is worthless and the company is required to write it off.

US GAAP

U.S. GAAP has very specific rules regarding the recognition of intangible assets on financial statements. With that said, a company can still have very valuable intangible assets that are not recognized in its financial statements. From an accounting perspective, intangible asset valuation is primarily derived from acquisition costs. An acquisition identifies the value one party was willing to pay for an asset while at the same time identifying the value another party was willing to accept to relinquish that asset.

Goodwill is an excellent example of how intangible assets are valued. Let’s say Company A has net assets equal to 150,000 and is acquired by Company B for 200,000. Why would Company B pay a 50,000 premium? Goodwill! Company B believes that Company A has value in excess of their net identifiable assets, and was willing to pay an additional 50,000 to acquire it. The 50,000 value of Company A’s goodwill was derived from a transaction.

Key Takeaways

  • Amortization is the accounting process used to spread the cost of intangible assets over the periods expected to benefit from their use.
  • The customary method for amortization is the straight-line method.
  • Determining which intangible assets may be amortized and the correct capitalized value can sometimes be tricky.
  • Amortization rules differ significantly for tax versus book purposes. But applied correctly, the amortization can result in significant tax savings.

Amortization vs. Depreciation: What’s the Difference?

Amortization and depreciation are similar in that they both support the GAAP matching principle of recognizing expenses in the same period as the revenue they help generate.

However, there are significant differences between them.

  • Intangible vs. tangible assets: Amortization is used for intangible assets, while depreciation is used for tangible, fixed assets such as office equipment or buildings.
  • Cause of reduced asset value: Amortization generally reflects an intangible asset’s loss in value due to circumstances like contract expiration or obsolescence. In contrast, depreciation reflects the fact that a fixed asset loses value as it wears out or becomes consumed.
  • Applicability: Amortization applies only to intangible assets with finite, identifiable useful lives and not those with indefinite useful lives, while depreciation is generated for every fixed asset, excluding land.
  • Salvage value: Amortization is most often calculated on the entire value of an intangible asset, while depreciation typically assumes that a fixed asset has a salvage value.
  • Journal entries: Amortization expense is charged (debited) to the P&L expense account with an offsetting credit directly in the intangible asset account. In contrast, depreciation is credited to accumulated depreciation, a contra-asset account.

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