Amortization of Intangibles: Definition, How It Works, Types, and Examples
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Summary:
The amortization of intangibles, often referred to simply as amortization, is the process of gradually expensing the cost of intangible assets like patents and trademarks over their projected lifespan for tax or accounting purposes. While tangible assets are depreciated, intangible assets are amortized. In this comprehensive guide, we’ll delve into the world of amortization, discussing its key takeaways, methods, and its crucial role in both tax and accounting. Additionally, we’ll explore the differences between amortization and depreciation and provide examples to illustrate the concepts.
Understanding amortization of intangibles
Amortization of intangible assets is a financial process that involves systematically expensing the cost of such assets over a period of time. Unlike tangible assets, which are subject to depreciation, intangible assets like patents, trademarks, and intellectual property are subject to amortization.
For tax purposes, intangible assets are typically amortized over a 15-year period, as specified by the Internal Revenue Service (IRS). These assets include patents, goodwill, trademarks, and trade and franchise names.
However, there are exceptions, such as software that is readily available to the public, subject to a nonexclusive license, and has not been substantially modified. In such cases, intangibles are amortized under different rules.
Special considerations
When a parent company acquires a subsidiary for an amount exceeding the fair market value of the subsidiary’s net assets, the excess amount is recorded as goodwill, an intangible asset. Intellectual property can also be internally generated through a company’s research and development efforts. In either case, amortization allows the company to gradually write off a portion of the intangible asset’s value over time.
Amortization vs. depreciation
Both amortization and depreciation serve the purpose of matching the costs of assets with the revenues they generate, as per generally accepted accounting principles (GAAP).
Depreciation is used for tangible assets and includes accounting for a salvage value—the expected resale value of the asset at the end of its useful life. In contrast, amortization does not consider a salvage value and is applied to intangible assets.
Types of amortization
For accounting purposes, companies have six options for amortization methods: straight line, declining balance, annuity, bullet, balloon, and negative amortization. In contrast, there are only four depreciation methods available for tangible assets.
For tax purposes, the IRS permits two amortization options for intangibles: straight line and the income forecast method, depending on the type of asset. Depreciation of physical assets, on the other hand, follows the Modified Accelerated Cost Recovery System (MACRS).
Example of amortization
Let’s illustrate amortization with examples:
- A construction company purchases a $32,000 truck with an expected useful life of eight years. Using the straight-line method, the annual depreciation is $3,500.
- A corporation acquires a patent for $300,000, granting exclusive rights for 30 years. The company records an annual amortization expense of $10,000 for 30 years.
While the truck undergoes depreciation as a physical asset, the patent experiences amortization as an intangible asset.
Defining amortization of intangibles
The term “amortization of intangibles” refers to the process of gradually expensing costs associated with intangible assets, such as patents and trademarks, over their expected lifespan. This accounting practice is crucial for tax and financial reporting purposes and involves allocating the asset’s cost over time.
Calculating amortization of intangibles
Amortization can be calculated using various methods, with the straight-line method being the most common. This involves deducting the anticipated salvage or book value from the asset’s cost and dividing the result by the asset’s expected lifespan.
Locating amortization of intangibles on financial statements
On a company’s financial statements, amortization of intangibles, often simply called “amortization,” appears as an expense under the expenses category on the profit and loss statement. It is also recorded in the non-current assets section of the corporate balance sheet.
Frequently asked questions
What are intangible assets?
Intangible assets are non-physical assets that hold economic value. They encompass various forms of intellectual property, including patents, trademarks, and copyrights.
How does amortization differ from depreciation?
Amortization is the process of expensing intangible assets over time, while depreciation applies to tangible assets. Depreciation factors in a salvage value, while amortization does not.
What are the common amortization methods?
For accounting purposes, companies can choose from six amortization methods, including straight line, declining balance, annuity, bullet, balloon, and negative amortization. Tax purposes generally permit straight line or the income forecast method.
Where can I find amortization of intangibles on financial statements?
Amortization of intangibles is typically listed under the expenses category on the profit and loss statement and appears in the non-current assets section of the corporate balance sheet.
Key takeaways
- Amortization is the gradual expensing of intangible assets over time, distinct from depreciation for tangible assets.
- Intangible assets encompass intellectual property like patents, trademarks, and copyrights.
- Amortization methods include straight line, declining balance, annuity, bullet, balloon, and negative amortization for accounting purposes.
- For tax purposes, intangibles can be amortized using the straight-line or income forecast method.
- Amortization and depreciation ensure expenses align with asset use and revenue generation.
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