Amortizing Intangible Assets for Financial Clarity
Amortization of intangibles, commonly referred to as amortization, is the process of distributing the cost of an intangible asset over its anticipated useful lifespan for accounting or tax purposes. These non-physical assets, such as patents and trademarks, are recorded as expenses in an amortization account. In contrast, tangible assets are expensed through depreciation. The specific practices of amortization in corporate accounting may differ from those used for tax reporting.
Key Takeaways
- Incremental Expensing: Amortization spreads the cost of an intangible asset over time, incrementally writing it off.
- Intangibles vs. Tangibles: Amortization is used for intangible assets whereas depreciation is for tangible assets.
- Categories Included: Intellectual property including patents, goodwill, trademarks can be amortized.
- Tax Period: For tax purposes, most intangibles are amortized over a 15-year period.
- Methods: Six different amortization methods can be used in accounting, adapting the expense over time in various ways.
In-Depth Understanding of Amortization
From a tax perspective, the cost basis of an intangible asset is amortized over a specified period, often 15 years as dictated by Section 197. Regardless of their actual useful life, these assets must conform to defined schedules set by tax authorities such as the Internal Revenue Service (IRS). Examples of such Section 197 intangible assets include patents, goodwill, trademarks, and trade names.
Certain exclusions apply, such as software acquired for public use subject to a nonexclusive license. These are amortized under Section 167. Adhering to Generally Accepted Accounting Principles (GAAP), businesses synchronize amortization with revenue generation to match expenses within the relevant accounting period.
Special Considerations
When a parent company buys a subsidiary for more than its fair market value (FMV), the excess amount becomes goodwill. Internally generated intellectual property through research and development (R&D) such as patents also contribute to the company’s assets. Both acquired and internally developed intangible assets must be amortized according to predefined schedules.
Contrasting Amortization and Depreciation
Amortization and depreciation serve similar functions by spreading out asset costs over time. However, whereas amortization handles non-physical assets, depreciation covers physical ones. Depreciation accounts for salvage value, representing the residual worth at the end of an asset’s useful life; amortization does not include a salvage value.
Types of Amortization
Corporations have multiple options for financial statement amortization: straight line, declining balance, annuity, bullet, balloon, and negative amortization methods. Tax reporting allows the straight line and income forecast methods for amortization.
Example of Amortization
For instance, consider a construction firm purchasing a $32,000 truck with an eight-year life span. The straight-line depreciation expense amounts to $3,500 per year after deducting the $4,000 salvage value. Conversely, a corporation investing $300,000 in a 30-year patent will post a $10,000 annual amortization expense. The truck’s depreciation and the patent’s amortization both reflect the costs tied to revenue generation.
Defining Amortization of Intangibles
Amortization of intangibles involves expensing the costs associated with intangible assets over their useful life—commonly done to align with accounting and taxation standards. These assets are recorded in an amortization account and expensed accordingly.
Calculating Amortization of Intangibles
The straightforward method of calculating amortization involves the straight line approach. It divides the asset’s cost (net of salvage value) by its useful life to determine the annual expense.
Reporting Amortization of Intangibles
Amortization expenses appear in the profit and loss statement under expenses and on the balance sheet under non-current assets, reflecting the gradual release of value from these intangible assets over time.
Related Terms: depreciation, intellectual property, tax basis, goodwill, financial statements.
References
- Internal Revenue Service. “Intangibles”.
- Cornell Legal Information Institute. “26 CFR § 1.197-2 - Amortization of goodwill and certain other intangibles”.
- Internal Revenue Service. “Section 167.– Depreciation”.
- Ruchelman P.L.L.C. “Taxation of Intellectural Property - The Basics”.
- Internal Revenue Service. “Instructions for Form 4562”.
- Internal Revenue Service. “Publication 946 (2020), How To Depreciate Property”.
