Companies invest in numerous assets to facilitate their operations and development. Although not all assets are physical like buildings and equipment, there are others that are non-physical but equally important. Intangible assets are referred to as these non-physical assets. Because a lot of intangible assets have benefits that last more than a year, companies need to spread their cost across the useful life of the intangible asset in a process known as amortization.
Knowledge on amortization of intangible assets is significant to business owners, accountants, investors, and other financial experts. It helps ensure accurate financial reporting and compliance with accounting standards.
This article defines amortization, its significance, the examples of intangible assets, and calculates it.
What Is Amortization of Intangible Assets?
Amortization of intangible assets is the accounting procedure of decreasing the value of an intangible asset over its useful life. Businesses do not recognize the full cost as an expense when buying an asset but rather spread the expense over the years that the asset is used to produce benefits.
Amortization is akin to depreciation, but there is one significant difference. Depreciation is used with tangible assets like machinery and vehicles whereas amortization is used with intangible assets like patents, copyrights and trademarks.
Amortization is meant to equal the cost of an asset to the revenue that it assists in generating over time.
Why Is Amortization Important?
Amortization is an important aspect of financial accounting and reporting. It assists businesses to show a more realistic image of their financial results and assets.
Amortization has some major advantages such as:
- Maintains adherence to accounting principles.
- Matches expenses with the revenue generated.
- Gives a fair value of assets.
- Improves the accuracy of financial statements.
- Assists companies in strategizing future investments and budgets.
In the absence of amortization, the profits of a company may seem to be much less in the year of acquisition and much higher in subsequent years.
Understanding Intangible Assets
Intangible assets refer to non-physical resources that are of long-term economic value to a business. They may not be touchable or visible but they tend to add value to the value and competitive advantage of a company.
Intangible assets can be broadly classified as:
Finite-life intangible assets: Assets that have a finite useful life and can be amortized.
Indefinite-life intangible assets: Assets that have no predictable end date, and are generally not amortized, but are impaired.
Amortization is only applicable to finite-life intangible assets.
Common Examples of Amortizable Intangible Assets
Intangible assets owned by many businesses have to be amortized.
The most typical ones are:
Patents
A patent provides the inventor with a monopoly to produce or market an invention within a certain time. Patents are amortised over their useful life since they have a legal life.
Copyrights
Copyrights safeguard creative works like books, music, movies and software. The useful life of a copyright can be amortised against the acquisition cost.
Licensing Agreements
Licenses are commonly sold to businesses to enable them to utilize a certain technology, software, or intellectual property. These licenses are usually amortised during the period of the agreement.
Customer Lists
Purchased customer databases can be used to generate future revenue, and are typically amortised over their useful life.
Franchise Rights
Franchise right purchasers are able to amortize the expense throughout the duration of the franchise contract.
Intangible Assets That Are Not Amortized
Not all intangible assets undergo amortization. Assets whose useful life is indefinite are not usually subject to this process.
Examples include:
- Some trademarks that have no expiry date.
- Unlimited useful life brand names.
These assets are not amortized but periodically tested to determine impairment. When their value drops by a large margin, the business is charged with an impairment loss.
It is important to understand the distinction between finite and indefinite-life assets to treat them appropriately.
How Amortization Is Calculated
The straight-line method is the most popular way to compute amortization. This method distributes the cost of the asset evenly during its useful life.
Formula for Amortization
Annual Amortization Expense = Cost of Intangible Asset/Useful Life.
Where:
- Cost of Intangible Asset = Purchase price or acquisition cost.
- Useful Life = Number of years that the asset is estimated to be of benefit.
The straight-line method is common since it is easy and it is in line with the normal accounting practices.
Example of Amortization Calculation
We will consider a practical example.
Assume that a firm buys a patent at a cost of 100,000. The useful life of the patent is 10 years.
Based on the straight-line formula:
- Annual Amortization Expense = $100,000 ÷ 10
- Annual Amortization Expense = $10,000
This implies that the company will amortize the cost of $10,000 annually over a period of ten years.
The accounting records would show:
Initial Asset Value: $100,000
Year 1 Carrying Value: $90,000
Year 2 Carrying Value: $80,000
Year 3 Carrying Value: $70,000
This is repeated until the carrying value of the asset is zero or the residual value of the asset, where applicable.
Amortization and Financial Statements
Amortization has an impact on various financial statements and accounting records.
Income Statement
The amortization cost is charged as an operating expense every year and decreases the net income of the company.
Balance Sheet
The accumulated amortization of the intangible asset reduces the carrying value of the asset every year.
Cash Flow Statement
Amortization is a non-cash expense, which decreases accounting profit, but does not entail a cash outlay during the amortization period.
Amortization expenses are usually examined by investors and analysts in the determination of the profitability and long-term management of assets of a company.
Best Practices for Managing Intangible Asset Amortization
To make sure that the amortization reporting is accurate, businesses should adhere to a few best practices:
- Keep comprehensive documentation of all purchases of intangible assets.
- Check helpful life estimates on a regular basis.
- Adhere to relevant accounting rules and regulations.
- Track assets to detect impairment.
- Automate calculations and reporting using accounting software.
Proper management of intangible assets assists business to avoid reporting errors and transparency in financial statements.
Amortization of intangible assets is an accounting practice that is essential and the cost of finite-life intangible assets is distributed over the period the assets benefit the economy. It assists companies to precisely align costs against revenue, enhance financial reporting and adhere to accounting standards.
The typical amortizable assets are patents, copyrights, licenses, customer lists and franchise rights. The most common method of calculating amortization is the straight-line method due to its simplicity and efficiency.
Knowing the amortization process and using it properly will allow businesses to make more sound financial choices, keep accurate records and paint a more accurate picture of their overall financial well-being.
