Amortization Of Intangible Assets – Definition, Examples, and Calculation

Introduction

In the world of finance, not all assets are tangible. Some of the most valuable assets of a company, such as patents, trademarks, and goodwill, are intangible. But how do businesses account for these non-physical assets over time? This is where the concept of amortization of intangible assets comes into play.

Imagine owning a patent for a groundbreaking technology. This patent doesn’t wear out like machinery, but its value diminishes over time due to competition and new innovations. Amortization helps companies allocate the cost of such intangible assets over their useful life, ensuring accurate financial reporting and better decision-making.

In this comprehensive blog, we will unravel the complexities of amortization of intangible assets with examples and step-by-step calculations, helping you understand how these assets are accounted for

What is Amortization of Intangible Assets?

Amortization of intangible assets is the systematic process of expensing the cost of an intangible asset over its useful life. This practice helps match the expense with the revenue generated by the asset, ensuring accurate financial reporting. Intangible assets include patents, copyrights, trademarks, and goodwill.

Amortization is similar to depreciation, but while depreciation applies to tangible assets (like buildings and machinery), amortization is used for intangible assets. The main goal is to match the expense of the asset with the revenue it generates over time, ensuring a more accurate representation of a company’s financial health.

Key points to remember

1. Intangible assets: Assets without a physical form but with value, such as patents, copyrights, and trademarks.
2. Useful life: The period during which the intangible asset is expected to be useful to the business. This is often determined by legal or contractual limits, such as the length of a patent.
3. Systematic expensing: Amortization spreads the cost of the asset evenly over its useful life, typically on a straight-line basis.

Understanding the amortization of intangible assets is essential for accurate financial reporting and strategic business planning. It ensures that the costs associated with these assets are appropriately matched with the revenues they help to generate, adhering to the matching principle of accounting.

Types of Intangible Assets

Intangible assets can be broadly classified into two main categories: identifiable and unidentifiable. Each category encompasses various types of intangible assets that businesses might own.

Identifiable intangible assets

These are assets that can be separated from the company and sold, transferred, licensed, rented, or exchanged. They often have legal rights associated with them.

1. Patents: Legal rights granted for an invention, allowing the patent holder exclusive rights to use, sell, or license the invention for a certain period, typically 20 years.
2. Trademarks: Distinctive signs, logos, or names that identify products or services and distinguish them from competitors. Trademarks can last indefinitely as long as they are in use and properly protected.
3. Copyrights: Legal protections for original works of authorship, such as books, music, and art, usually lasting the life of the author plus 70 years.
4. Franchises: Rights granted to operate a business using the branding and operational methods of another company.
5. Licenses: Permissions granted to use another company’s intellectual property.

Unidentifiable intangible assets

These are assets that cannot be separated from the company and are often difficult to quantify or value.

1. Goodwill: The excess value paid during the acquisition of a company, reflecting the reputation, customer relationships, and other unidentifiable factors that contribute to future earnings.
2. Brand recognition: The value derived from consumer awareness and trust in a brand, leading to customer loyalty and repeat business.

Factors that Determine the Life of an Intangible Asset

Understanding the types of intangible assets and the factors determining their useful life is crucial for accurate amortization and financial reporting. This knowledge helps businesses make informed decisions about managing and leveraging their intangible assets effectively.

The useful life of an intangible asset can be influenced by various factors, including:

1. Legal or contractual provisions: The duration of legal protection or contract terms, such as the length of a patent or copyright.
2. Economic factors: Market demand, competition, and technological advancements that can impact the asset’s revenue-generating ability.
3. Usage: The extent and manner in which the asset is used in the business operations.

How to Calculate Amortization of Intangible Assets

Calculating the amortization of intangible assets involves determining the annual expense that will be recorded over the asset’s useful life. This process helps allocate the cost of the asset systematically.

Formula for amortization

The most common method used for amortizing intangible assets is the straight-line method. The formula for calculating annual amortization expense using this method is:

Where,

1. Initial Cost of the Asset: The total cost incurred to acquire the intangible asset.
2. Residual Value: The estimated value of the asset at the end of its useful life (often assumed to be zero for intangible assets).

Steps for calculation:

1. Determine the initial Cost: Identify the total cost incurred to acquire the intangible asset.
2. Establish the residual value: Estimate the value of the asset at the end of its useful life (if any).
3. Determine the useful life: Assess the period over which the asset will be useful.
4. Calculate the annual expense: Use the formula to determine the annual amortization expense.
5. Record the expense: After calculating the annual amortization expense, prepare an amortization schedule. Each year, record the amortization expense in the financial statements.

Amortization of Intangible Assets Example

To better understand how amortization of intangible assets works, let’s look at a practical example.

Imagine a company, ABC Inc., acquires a patent for a new technology. The cost of obtaining the patent is $100,000, and the patent has a useful life of 10 years, and no residual value.

1. Initial cost: $100,000
2. Residual value: $0
3. Useful life: 10 years

Using the formula:

Annual Amortization Expense = $100,000 − $0/$10 = $10,000

ABC Inc. utilizes the straight-line method of amortization, and each year they will record an amortization expense of $10,000. 

Methods to Amortize Intangible Assets

Amortizing intangible assets involves different methods to allocate the cost over the asset’s useful life. While the straight-line method is the most common, there are other methods that businesses might use depending on their specific circumstances.

• Declining balance method

  The declining balance method applies a constant rate of amortization to the remaining book value of the asset each year. This method results in higher expenses in the early years and lower expenses in the later years.

  Annual Amortization Expense = Book Value at Beginning of Year × Declining Balance Rate

  Example:

  If a company uses a 20% declining balance rate for an intangible asset worth $50,000, the first year’s amortization expense would be:

  First Year Expense = $50,000 × 20% = $10,000

  The remaining book value for the second year would be $40,000, and so forth.

• Units of production method

  This method amortizes the asset based on its usage, output, or another measurable factor, rather than time. It is suitable for assets whose economic benefits are more closely related to their usage.

  Amortization Expense = [(Cost − Residual Value)/Total Estimated Production] × Actual Production

  Example:

  Let’s say a publishing company acquires a copyright for a series of educational books costing $200,000, with an estimated total production of 500,000 copies, and no residual value. If the company produces 50,000 copies in the first year, the annual amortization expense would be:

  Amortization Expense = [($200,000 − $0)/500,000] × 50,000 = $20,000

• Sum-of-the-Years’-Digits Method

  This accelerated method results in higher amortization expenses in the earlier years and lower expenses in the later years. It uses a fraction of the asset’s remaining life relative to the sum of the years’ digits.

  Amortization Expense = (Remaining Life of Asset/Sum of the Years’ Digits) × (Cost−Residual Value)

  Example:

  For an intangible asset with a useful life of 5 years, the sum of the years’ digits is:

  5 + 4 + 3 + 2 + 1 = 15 

  In the first year, the amortization expense fraction would be: 5/15

  This fraction decreases each year as follows:

  Second year: 4/15

  Third year: 3/15

  Fourth year: 2/15

  Fifth year: 1/15

  These methods offer flexibility in how businesses can match the expense of their intangible assets to their revenue recognition patterns, ensuring accurate and fair financial reporting.

The Role of AI in Amortization of Intangibles

In today’s digital age, artificial intelligence is revolutionizing the way businesses handle their accounting processes, including the amortization of intangibles. AI can significantly enhance the accuracy, efficiency, and reliability of amortization practices through several key ways:

1. Automated calculations: AI-powered accounting software can automate the calculation of amortization expenses, reducing the risk of human error and ensuring consistency in financial reporting.
2. Predictive analysis: AI can analyze historical data and market trends to predict the useful life of intangible assets more accurately, helping businesses make better-informed decisions.
3. Dynamic adjustments: AI systems can continuously monitor the performance and usage of intangible assets, making dynamic adjustments to amortization schedules as needed based on real-time data.
4. Regulatory compliance: AI can help ensure compliance with evolving accounting standards and regulations by automatically updating processes and calculations to reflect the latest requirements.
5. Enhanced Reporting: AI can generate detailed and insightful financial reports that provide a deeper understanding of the impact of intangible assets on a company’s financial health, aiding in strategic planning and decision-making.

How Highradius Can Help?

HighRadius offers a cloud-based Record to Report Suite that helps accounting professionals streamline and automate the financial close process for businesses. We have helped accounting teams from around the globe with month-end closing, reconciliations, journal entry management, intercompany accounting, and financial reporting.

Our Financial Close Software is designed to create detailed month-end close plans with specific close tasks that can be assigned to various accounting professionals, reducing the month-end close time by 30%.The workspace is connected and allows users to assign and track tasks for each close task category for input, review, and approval with the stakeholders. It allows users to extract and ingest data automatically, and use formulas on the data to process and transform it. 

Our Account Reconciliation Software provides an out-of-the-box formula set that can configure matching rules and match line-level transactions from multiple data sources and create templates to automate various transaction processing required for month-end close. Our solution has the ability to prepare and post journal entries, which will be automatically posted into the ERP, automating 70% of your account reconciliation process. 

Our AI-powered Anomaly Management Software helps accounting professionals identify and rectify potential ‘Errors and Omissions’ throughout the financial period so that teams can avoid the month-end rush. The AI algorithm continuously learns through a feedback loop which, in turn, reduces false anomalies. We empower accounting teams to work more efficiently, accurately, and collaboratively, enabling them to add greater value to their organizations’ accounting processes.

FAQs

1) Is amortization of intangible assets important?

Amortization of intangible assets is crucial for accurate financial reporting and expense matching while maintaining transparency. It allocates the cost of intangible assets, such as patents or trademarks, over their useful life, ensuring that expenses are matched with the revenue generated. 

2) How long can I amortize intangible assets?

The amortization period for intangible assets depends on their useful life, which can be influenced by legal, contractual, and economic factors. Typically, the period ranges from a few years to the length of legal protection. For example, patents are amortized over 20 years, while copyrights last the author’s life plus 70 years.

3) Which intangible asset is not amortized?

Goodwill is an intangible asset that is not amortized. Instead, it is tested annually for impairment. Goodwill arises when a company acquires another company for more than the fair value of its net identifiable assets. This asset reflects the value of a business’s reputation, brand, and customer relationships.

4) What is the maximum amortization period for intangible assets?

The maximum amortization period for intangible assets typically aligns with their legal or useful life. For instance, patents have a maximum amortization period of 20 years. However, the specific period can vary depending on the asset type and jurisdiction, but it generally should not exceed 40 years.

5) What is the difference between amortization and depreciation?

Amortization and depreciation both allocate the cost of an asset over its useful life. Amortization deals with intangible assets like patents and copyrights, while depreciation applies to tangible assets such as machinery and buildings. Both methods ensure accurate expense matching and financial reporting.