Intangible assets are non-physical assets on a company’s balance sheet. These could include patents, intellectual property, trademarks, and goodwill. Intangible assets could even be as simple as a customer list or franchise agreement.
Some of these intangible assets have a finite useful life.
While physical assets can wear down over time and lose value just from use, their intangible counterparts wear down through contract expirations, obsolescence, and other non-physical factors.
If an intangible asset has a finite useful life, the company is required to amortize it, a process very similar to how physical assets are depreciated over time.
What does amortization actually mean?
The process of amortization in accounting reduces the value of the intangible asset on the balance sheet over time and reports an expense on the income statement each period to reflect the change on the balance sheet during the given period.
Like depreciation, there are multiple methods a company can use to calculate an intangible asset’s amortization, but the simplest is the straight-line method.
With the straight-line method, the company starts with the asset’s recorded value, its residual value, and its useful life.
The recorded value is the initial value assigned to the asset on the books, generally meaning its price or cost to create.
Its residual value is the expected value of the asset at the end of its useful life.
For most intangible assets, the residual value is zero as many intangible assets are considered worthless once they’ve been fully utilized.
The useful life of the asset is the period of time over which the company expects the intangible asset to provide economic value to the business.
The mechanics of the amortization calculation are otherwise the same as calculating depreciation with the straight-line method. The company should subtract the residual value from the recorded cost, and then divide that difference by the useful life of the asset.
Each year, that value will be netted from the recorded cost on the balance sheet in an account called “accumulated amortization,” reducing the value of the asset each year. The income statement will show the reduction each year as an “amortization expense.”
An example calculation of the amortization of an intangible asset
Let’s say that a company has developed a software solution to be used internally to better manage its inventory.
The company does not intend to ever sell this software; it’s only to be used by company staff. This software is considered an intangible asset, and it must be amortized over its useful life.
First, the company will record the cost to create the software on its balance sheet as an intangible asset. The software cost the company $10,000, in this case.
Next, the company estimates that the software will have a useful life of just three years given the fast paced nature of software innovation.
At the end of three years, the company reckons that their internal software will have no remaining value, so its residual value is therefore zero.
The company will use the straight-line method to report the amortization of the software.
Subtracting the residual value — zero — from the $10,000 recorded cost and then dividing by the software’s three-year useful life, the company’s accountants determine the annual amortization for the software to be $3,333.
Each year, the net asset value for the software will reduce by that amount and the company will report $3,333 in amortization expense.
Here’s a breakdown of how the balance sheet and income statement will reflect this amortization over the three-year period
When intangible assets should not be amortized
Most physical capital assets will depreciate over time.
Land is one of the rare examples where a physical asset should never be depreciated. For intangible assets though, it’s much more common to have an asset than should not be amortized.
This derives from the fact that more intangible assets have indefinite useful lives than physical assets.
If an intangible asset will continue to provide economic value without deterioration over time, then it should not be amortized. Instead, its value should be periodically reviewed and adjusted with an impairment.
Goodwill, for example, is an intangible asset that should never be amortized.
If goodwill is to be changed, that should occur through the process of impairment, where the value of the asset is changed based on specific, changing conditions rather than based on a calculated schedule as would be the case with amortization.
Goodwill is the portion of a business’ value not attributable to other assets. Goodwill is a common result of acquisitions where the purchase price is greater than the fair market value of the assets and liabilities.
View more information: https://www.fool.com/the-blueprint/amortization-of-intangible-assets/