9.2 Amortization of intangibles
6 min read•august 20, 2024
Intangible assets are non-physical resources that provide future economic benefits to companies. These assets, such as , , and , play a crucial role in modern businesses. Proper accounting for intangibles is essential for accurately reflecting a company's financial position and performance.
is the systematic allocation of an intangible asset's cost over its . This process involves determining the asset's useful life, selecting an appropriate amortization method, and calculating the periodic expense. Understanding amortization is key to properly valuing and reporting intangible assets on financial statements.
Definition of intangible assets
- Intangible assets are non-physical assets that provide future economic benefits to a company
- Examples of intangible assets include patents, copyrights, trademarks, , and software
- Unlike tangible assets, intangible assets lack physical substance but still hold value for the company
Accounting for intangible assets
- Accounting for intangible assets involves recognizing, measuring, and reporting these assets in financial statements
- Proper accounting for intangibles is crucial for accurately reflecting a company's financial position and performance
Initial recognition of intangibles
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- Intangible assets are initially recognized at cost when acquired from an external party
- Cost includes the purchase price and any directly attributable costs incurred to prepare the asset for its intended use
- Internally generated intangibles are generally not recognized as assets due to the difficulty in reliably measuring their cost
Measurement of intangible assets
- After initial recognition, intangible assets are measured at cost less accumulated amortization and losses
- Some intangibles, such as goodwill, are not amortized but are instead tested annually for impairment
- Revaluation of intangible assets is generally not permitted under U.S. but is allowed under in certain circumstances
Amortization of intangibles
- Amortization is the systematic allocation of the cost of an intangible asset over its useful life
- is recognized in the each period, reducing the carrying value of the intangible asset
Amortization vs depreciation
- Amortization is used for intangible assets, while depreciation is used for tangible assets (property, plant, and equipment)
- Both amortization and depreciation allocate the cost of an asset over its useful life, but the terminology differs based on the nature of the asset
Determining useful life of intangibles
- The useful life of an intangible asset is the period over which it is expected to contribute to the company's cash flows
- Factors to consider when determining useful life include legal, regulatory, or contractual provisions that may limit the useful life
- Useful life may also be impacted by the effects of obsolescence, demand, competition, and other economic factors
Amortization methods for intangibles
- The most common amortization method for intangibles is the , which allocates the cost evenly over the asset's useful life
- Other amortization methods, such as the or the , may be used if they better reflect the pattern of economic benefits consumed
Calculation of amortization expense
- Amortization expense is calculated by dividing the asset's cost (less any ) by its estimated useful life
- The formula for straight-line amortization expense is:
- For example, if an intangible asset costs 10,000 and a useful life of 5 years, the would be 100,000 - $10,000) / 5 years]
Impairment of intangible assets
- Impairment occurs when the carrying amount of an intangible asset exceeds its fair value
- Impairment losses are recognized in the income statement, reducing the carrying value of the intangible asset
Indicators of intangible impairment
- External indicators of impairment include significant changes in the legal, technological, or economic environment that negatively impact the asset's value
- Internal indicators of impairment include obsolescence, physical damage, or a significant decline in the asset's performance or expected future cash flows
Impairment testing for intangibles
- Intangible assets with finite useful lives are tested for impairment when indicators of impairment are present
- Intangible assets with indefinite useful lives (such as goodwill) are tested for impairment at least annually, regardless of indicators
- Impairment testing involves comparing the asset's carrying amount to its fair value, which is determined using valuation techniques such as discounted cash flow analysis or market comparisons
Measuring and recording impairment losses
- If the fair value of an intangible asset is less than its carrying amount, an impairment loss is recognized in the income statement
- The impairment loss is calculated as the difference between the asset's carrying amount and its fair value
- After an impairment loss is recognized, the asset's new carrying amount becomes its new cost basis for future amortization
Presentation and disclosure of intangibles
- The presentation and disclosure of intangible assets in financial statements provide important information to stakeholders about the company's resources and future economic benefits
Balance sheet presentation of intangibles
- Intangible assets are reported on the as non-current assets, separate from tangible assets
- Intangibles are typically presented at their carrying amount, which is cost less accumulated amortization and impairment losses
Disclosure requirements for intangibles
- Companies must disclose the gross carrying amount and accumulated amortization for each major class of intangible assets
- Disclosure should also include the weighted-average amortization period for each major class of intangibles
- Any changes in the estimated useful life or amortization method must be disclosed and treated as a change in accounting estimate
Amortization expense in income statement
- Amortization expense for intangible assets is reported in the income statement, typically as part of operating expenses
- Amortization expense should be presented separately from other expenses, such as depreciation expense for tangible assets
Special considerations for intangibles
- Certain types of intangible assets require special accounting treatment due to their unique characteristics
Intangibles with indefinite useful lives
- Some intangible assets, such as certain trademarks or perpetual franchises, may have indefinite useful lives
- Intangibles with indefinite useful lives are not amortized but are instead tested annually for impairment
- If an intangible asset's useful life changes from indefinite to finite, amortization begins from that point forward
Internally generated intangible assets
- Internally generated intangibles, such as research and development costs, are generally expensed as incurred
- However, certain development costs may be capitalized if they meet specific criteria, such as technical feasibility and the intent and ability to complete and use or sell the asset
- Capitalized development costs are amortized over their estimated useful lives once the related asset is ready for use
Intangible assets acquired in business combinations
- When a company acquires another business, it may recognize additional intangible assets such as customer relationships, trade names, or in-process research and development
- These intangible assets are initially measured at fair value and amortized over their estimated useful lives
- Goodwill arising from the business combination is not amortized but is instead tested annually for impairment
Tax implications of intangible assets
- The tax treatment of intangible assets can differ from their accounting treatment, leading to temporary differences and deferred taxes
Amortization for tax purposes
- The Internal Revenue Code governs the amortization of intangible assets for tax purposes
- Some intangibles, such as goodwill and certain customer-related intangibles, are amortized over 15 years for tax purposes, regardless of their useful life for accounting purposes
- Other intangibles, such as patents and copyrights, are generally amortized over their legal lives or useful lives, whichever is shorter
Deferred tax assets and liabilities for intangibles
- Differences between the accounting and tax treatment of intangible assets create temporary differences
- These temporary differences give rise to deferred tax assets or liabilities, which are recognized on the balance sheet
- Deferred tax assets represent future tax deductions, while deferred tax liabilities represent future taxable amounts
- The recognition and measurement of deferred taxes related to intangibles follow the general principles of income tax accounting under ASC 740
Key Terms to Review (20)
Accelerated method: The accelerated method is a technique used for amortizing intangibles at a faster rate than the straight-line method, allowing for greater expense recognition in the earlier periods of an asset's useful life. This approach is particularly beneficial when the benefits of an intangible asset are expected to be realized more in the early years, aligning expenses with revenue generation. By front-loading the amortization, companies can reflect a more realistic portrayal of the asset's consumption over time.
Amortization: Amortization is the process of gradually reducing a financial obligation or intangible asset's value over time through scheduled payments or expense recognition. It plays a crucial role in accounting as it affects operating activities, impacts cash flows, and reflects the cost allocation of intangible assets and long-term liabilities.
Amortization expense: Amortization expense refers to the gradual allocation of the cost of an intangible asset over its useful life. This accounting method helps businesses spread out the expense related to an intangible asset, like patents or trademarks, thereby reflecting a more accurate financial position over time. It is important for assessing the value of long-term assets and impacts net income as it reduces taxable income.
Amortization Schedule: An amortization schedule is a detailed table that outlines each payment of a loan or intangible asset over time, showing how much of each payment goes towards interest and how much goes towards reducing the principal balance. It is crucial for understanding the repayment structure of loans, as well as tracking the amortization of intangible assets, which spreads the cost over their useful life.
Annual amortization expense: Annual amortization expense refers to the systematic allocation of the cost of an intangible asset over its useful life, reflecting the gradual consumption of the asset's value. This process helps businesses match the cost of intangible assets, like patents or copyrights, with the revenues they generate, ensuring accurate financial reporting and compliance with accounting principles.
Balance Sheet: A balance sheet is a financial statement that presents a company's financial position at a specific point in time, detailing its assets, liabilities, and equity. This essential report helps stakeholders assess the company's net worth, liquidity, and overall financial health, making it crucial for understanding how investing activities impact the balance of assets and liabilities.
Copyrights: Copyrights are legal protections granted to the creators of original works, such as literature, music, and art, giving them exclusive rights to use and distribute their creations. This concept is essential for recognizing and safeguarding intellectual property rights, which can be classified as intangible assets. Copyrights allow creators to control how their work is used, ensuring they receive recognition and financial benefits from their intellectual contributions.
GAAP: GAAP, or Generally Accepted Accounting Principles, is a collection of commonly followed accounting rules and standards for financial reporting. It establishes a framework for consistent financial reporting, ensuring that companies present their financial statements in a way that is understandable and comparable across different organizations. This standardization is crucial for investors, regulators, and other stakeholders who rely on accurate financial information to make informed decisions.
Goodwill: Goodwill is an intangible asset that represents the excess value of a business beyond its identifiable net assets at the time of acquisition. It often reflects factors such as brand reputation, customer relationships, and employee relations that contribute to future earnings. Goodwill is important in understanding types of intangible assets and plays a role in amortization, impairment assessments, and consolidation processes.
Historical Cost Principle: The historical cost principle states that assets should be recorded and reported at their original purchase price, which is the amount paid to acquire the asset, including any costs necessary to prepare the asset for its intended use. This principle emphasizes reliability and objectivity in financial reporting, as it relies on verifiable transactions rather than estimates or future values. It plays a crucial role in various accounting processes, impacting investment decisions, valuation of assets, and the evaluation of financial performance.
IFRS: International Financial Reporting Standards (IFRS) are accounting standards developed by the International Accounting Standards Board (IASB) that aim to bring transparency, accountability, and efficiency to financial markets around the world. These standards provide a common global language for business affairs so that financial statements are comparable across international boundaries, promoting cross-border investment and economic growth.
Impairment: Impairment refers to a permanent reduction in the value of an asset, indicating that its carrying amount exceeds its recoverable amount. This concept is crucial for recognizing losses on assets, ensuring that financial statements present an accurate view of a company's financial health. Impairment can affect various asset types, including notes receivable, acquisition costs, intangible assets, and available-for-sale securities, impacting both balance sheets and income statements.
Income Statement: An income statement is a financial document that summarizes a company's revenues, expenses, and profits over a specific period. It provides insight into the company's operational performance, helping stakeholders assess how well the business is generating profit from its operations, managing costs, and ultimately determining net income.
Matching principle: The matching principle is an accounting concept that requires expenses to be matched with the revenues they help to generate in the same period. This principle ensures that a company's financial statements accurately reflect its profitability and financial performance by aligning income and related expenses within the same time frame.
Patents: Patents are exclusive rights granted by a government to an inventor or assignee for a limited period of time, typically 20 years, allowing them to exclude others from making, using, selling, or distributing their invention without permission. This legal protection encourages innovation by ensuring that inventors can reap the financial benefits of their creations, linking patents closely to long-term assets as they can represent significant value on a company's balance sheet.
Residual value: Residual value is the estimated amount that an asset is expected to be worth at the end of its useful life. This figure is crucial as it impacts the calculations for depreciation, amortization, and depletion, which determine how much of an asset's cost is allocated as an expense over time. Knowing the residual value helps businesses to effectively plan for future cash flows and investment recovery.
Straight-line method: The straight-line method is a commonly used accounting technique for allocating the cost of an asset evenly over its useful life. This approach provides a simple and consistent way to recognize expense, making it easier for businesses to predict their financial performance. It is particularly important in various aspects of financial accounting, such as asset acquisition, depreciation, and amortization, as well as in assessing long-term liabilities and bond payable calculations.
Trademarks: Trademarks are distinctive signs or symbols, such as words, phrases, logos, or designs, that identify and distinguish the source of goods or services of one entity from those of others. They play a crucial role in protecting a company's brand and reputation, making them a significant aspect of long-term assets, particularly intangible assets. Proper management and accounting for trademarks can involve aspects such as amortization and assessing impairment, ensuring that their value is accurately reflected in financial statements.
Units-of-production method: The units-of-production method is a depreciation calculation that allocates the cost of an asset based on its usage or production output over its useful life. This method connects the expense recognition to the actual wear and tear of an asset, making it more aligned with the asset's contribution to revenue generation. It's particularly useful for assets whose wear is more closely tied to output rather than time, leading to a more accurate reflection of an asset's value over time.
Useful Life: Useful life refers to the estimated duration for which an asset is expected to be usable for its intended purpose, often impacting how the asset is amortized, impaired, or depleted over time. This concept is critical as it determines the period over which costs are spread, influencing financial statements and tax implications. An accurate estimation of useful life helps in assessing asset value and informs strategic decisions regarding replacement or investment in new assets.