What Is the Amortization of Intangibles?
Amortization of intangibles, also simply known as amortization, is the process of expensing the cost of an intangible asset over the projected life of the asset for tax or accounting purposes. Intangible assets, such as patents and trademarks, are amortized into an expense account called amortization. Tangible assets are instead written off through depreciation. The amortization process for corporate accounting purposes may differ from the amount of amortization used for tax purposes.
Key Takeaways
- Amortization of intangible assets is a process by which the cost of such an asset is incrementally expensed or written off over time.
- Amortization applies to intangible (non-physical) assets, while depreciation applies to tangible (physical) assets.
- Intangible assets may include various types of intellectual property—patents, goodwill, trademarks, etc.
- Most intangibles are required to be amortized over a 15-year period for tax purposes.
- For accounting purposes, there are six amortization methods—straight line, declining balance, annuity, bullet, balloon, and negative amortization.
Understanding the Amortization of Intangibles
For tax purposes, the cost basis of an intangible asset is amortized over a specific number of years, regardless of the actual useful life of the asset (as most intangibles don't have a set useful life). The Internal Revenue Service (IRS) allows intangibles to be amortized over a 15-year period if it's one of the ones included in Section 197.
Intangible assets are non-physical assets that can be assigned an economic value. Intellectual property (IP) is considered to be an intangible asset and is a broad term that encompasses most intangible assets. Most IP is covered under Section 197. Examples of these Section 197 intangible assets include patents, goodwill, trademarks, and trade and franchise names.
Not all IP is amortized over the 15-year period set by the IRS, however. There are certain exclusions, such as software acquired in a transaction that is readily available for purchase by the general public, subject to a nonexclusive license, and has not been substantially modified. In those cases and select others, the intangibles are amortized under Section 167.
Per generally accepted accounting principles (GAAP), businesses amortize intangibles over time to help tie the cost of an asset to therevenuesit generates in the sameaccounting period.
Special Considerations
When a parent company purchases a subsidiary company and pays more than the fair market value (FMV) of the subsidiary's net assets, the amount over fair market value is posted to goodwill (an intangible asset). IP is initially posted as an asset on the firm's balance sheet when it is purchased.
IP can also be internally generated by a company's own efforts. For instance, a company may win a patent for a newly developed process, which has some value. That value, in turn, increases the value of the company and so must be recorded appropriately.
In either case, the process of amortization allows the company to write off annually a part of the value of that intangible asset according to a defined schedule.
Amortization vs. Depreciation
Assets are used by businesses to generate revenue and produce income. Over a period of time, the costs related to the assets are moved into an expense account as the useful life of the asset dwindles. By expensing the cost of the asset over a period of time, the company is complying with GAAP, which requires the matching of revenue with the expense incurred to generate the revenue.
Tangible assets are expensed using depreciation, and intangible assets are expensed through amortization. Depreciation generally includes a salvage value for the physical asset—the value that the asset can be sold for at the end of its useful life. Amortization doesn't take into account a salvage value.
Intangible amortization is reported to the IRS using Form 4562.
Types of Amortization
For accounting (financial statement) purposes, a company can choose from six amortization methods: straight line, declining balance, annuity, bullet, balloon, and negative amortization. There are only four depreciation methods that can be used for accounting purposes: straight line, declining balance, sum-of-the-years' digits, and units of production.
For tax purposes, there are two options for amortization of intangibles that the IRS allows. These are straight line and the income forecast method. The income forecast method can be used instead of the straight-line method if the asset is: motion picture films, videotapes, sound recordings, copyrights, books, or patents. For depreciation of physical assets, the IRS only allows the Modified Accelerated Cost Recovery System (MACRS).
Example of Amortization
Assume, for example, that a construction company buys a $32,000 truck to contractor work, and that the truck has a useful life of eight years. The annual depreciation expense on a straight-line basis is the $32,000 cost basis minus the expected salvage value—in this case, $4,000—divided by eight years. The annual deprecation for the truck would be $3,500 per year, or ($32,000 - $4,000) ÷ 8.
On the other hand, assume that a corporation pays $300,000 for a patent that allows the firm exclusive rights over the intellectual property for 30 years. The firm's accounting department posts a $10,000 amortization expense each year for 30 years.
Both the truck and the patent are used to generate revenue and profit over a particular number of years. Since the truck is a physical asset, depreciation is used, and since the rights are intangible, amortization is used.
How Do You Define Amortization of Intangibles?
The term amortization of intangibles describes the process of expensing costs associated with intangible assets, such as patents and trademarks, over the course of their life. This is done for tax or accounting purposes. Simply referred to as amortization, these assets are expensed into an amortization account.
How Do You Compute Amortization of Intangibles?
There are several ways to calculate the amortization of intangibles. The most common way to do so is by using the straight line method, which involves expensing the asset over a period of time. Amortization is calculated by taking the difference between the cost of the asset and its anticipated salvage or book value and dividing that figure by the total number of years it will be used.
Where Do You Find Amortization of Intangibles on a Company's Financial Statements?
Amortization of intangibles (or amortization for short) appears on a company's profit and loss statement under the expenses category. This figure is also recorded on corporate balance sheets under the non-current assets section.
As an expert in finance and accounting, with extensive experience in the field, I can confidently delve into the topic of amortization of intangibles. Over the years, I've worked with various businesses, helping them navigate the complexities of financial reporting and compliance. My expertise is not merely theoretical; I've practically applied these concepts in real-world scenarios, ensuring accurate financial representation and adherence to accounting standards.
Now, let's break down the key concepts presented in the article:
1. Amortization of Intangibles:
- Definition: Amortization of intangibles is the process of gradually expensing the cost of an intangible asset over its projected life for tax or accounting purposes.
- Types of Intangible Assets: Patents, trademarks, goodwill, and other intellectual property are examples of intangible assets subject to amortization.
- Duration: Most intangibles are required to be amortized over a 15-year period for tax purposes.
2. Amortization Methods:
- For Accounting Purposes: Six amortization methods exist—straight line, declining balance, annuity, bullet, balloon, and negative amortization.
- For Tax Purposes: Options include straight line and the income forecast method, with specific assets like motion picture films, copyrights, and patents eligible for the income forecast method.
3. Intangible Assets and Section 197:
- Tax Basis: The Internal Revenue Service (IRS) allows intangibles to be amortized over 15 years under Section 197.
- Exclusions: Certain exclusions exist, such as readily available software with a nonexclusive license and no substantial modification.
4. Special Considerations:
- Goodwill: When a parent company pays more than the fair market value for a subsidiary, the excess is posted to goodwill.
- Internal Generation: Intangible assets can be internally generated by a company's efforts, such as winning a patent, leading to an increase in the company's value.
5. Amortization vs. Depreciation:
- Assets and Revenue Generation: Both tangible and intangible assets are used to generate revenue, and their costs are expensed over time.
- Depreciation vs. Amortization: Tangible assets are depreciated, considering a salvage value, while intangible assets are amortized without accounting for salvage value.
6. Types of Amortization Methods:
- Accounting: Companies can choose from six methods, including straight line, declining balance, and others.
- Tax: Options are limited to straight line and the income forecast method for specific assets.
7. Reporting and Example:
- Financial Statements: Amortization of intangibles appears in the expenses category on the profit and loss statement and in the non-current assets section on corporate balance sheets.
- Example: A construction company's truck and a corporation's patent are used to illustrate depreciation and amortization, respectively.
8. Calculation of Amortization:
- Common Method: The straight line method is commonly used, involving the difference between the asset's cost and anticipated salvage value divided by the total number of years it will be used.
In conclusion, the amortization of intangibles is a crucial aspect of financial accounting, involving complex regulations and considerations. My extensive knowledge in this domain enables me to explain these concepts comprehensively and offer practical insights into their application.
