Amortization of Intangible Assets

In This Article

• The amortization of intangible assets is the process of expensing the cost of non-physical assets like patents, trademarks, and copyrights over their useful life.
• The concept of amortization is practically the same as the depreciation of physical assets, but the reduction is applied to non-physical, intangible assets.
• The amortization expense reduces the carrying value of the intangible asset on the balance sheet until reaching zero at the end of its useful life.
• For tax purposes, most intangible assets must be amortized over 15 years per IRS Section 197, exceptions aside.
• The formula to calculate amortization is equal to the historical cost of the intangible asset subtracted by its residual value, which is then divided by the useful life assumption.

What is the Definition of Amortization?

How to Calculate Amortization of Intangible Assets

Intangible assets are defined as non-physical assets with useful life assumptions that exceed one year.

Similar to depreciation, amortization is effectively the “spreading” of the initial cost of acquiring intangible assets over the corresponding useful life of the assets.

Under the process of amortization, the carrying value of the intangible assets on the balance sheet is incrementally reduced until the end of the expected useful life is reached.

Note that the value of internally developed intangible assets is NOT recorded on the balance sheet.

Under accrual accounting, the “objectivity principle” requires financial reports to contain only factual data that can be verified, with no room for subjective interpretation.

Hence, internally developed intangible assets like branding, trademarks, and IP will not even appear on the balance sheet since they cannot be quantified and recorded in an unbiased way.

Companies are permitted to designate values to their intangible assets once the value is readily observable in the market – e.g. an acquisition where the price paid can be verified.

Since the purchase price can be confirmed, a portion of the excess amount paid could be allotted to the rights to owning the acquired intangible assets and recorded on the closing balance sheet (i.e. purchase accounting in M&A).

For tax reporting purposes in an asset sale/338(h)(10), most intangible assets are required to be amortized across a 15-year time horizon. But there are numerous exceptions to the 15-year rule, and private companies can opt to amortize goodwill.

^{IRS Section 197 (Source: IRS)}

Amortization of Intangible Assets Formula

Under the straight-line method, an intangible asset is amortized until its residual value reaches zero, which tends to be the most frequently used approach in practice.

The amortization expense can be calculated using the formula shown below.

Where:

• Historical Cost of Intangible Asset ➝ The historical cost refers to the amount paid on the initial date of purchase.
• Residual Value ➝ The residual value, or “salvage value”, is the estimated value of a fixed asset at the end of its useful life span. Most of the time, the residual value assumption is set to zero, meaning that the value of the asset is expected to be zero by the final period (i.e. worth no value).
• Useful Life ➝ The estimated number of years by which the intangible asset is expected to contribute positive economic value to the company.

Amortization vs. Depreciation: What is the Difference?

The amortization of intangible assets is closely related to the accounting concept of depreciation, except it applies to intangible assets instead of tangible assets such as PP&E.

Similar to PP&E, like office buildings and machinery, intangible assets such as copyrights, trademarks, and patents all offer benefits for greater than one year but have finite useful lives.

On the income statement, the amortization of intangible assets appears as an expense that reduces the taxable income (and effectively creates a “tax shield”).

Next, the amortization expense is added back on the cash flow statement in the cash from operations section, just like depreciation.  In fact, the two non-cash add-backs are typically grouped together in one line item, termed “D&A”.

The amortization expense reduces the appropriate intangible assets line item on the balance sheet—or in one-time cases, items such as goodwill impairment can affect the balance.

Capitalize vs. Expense: What is the Difference?

The deciding factor on whether a line item gets capitalized as an asset or immediately expensed as incurred is the useful life of the asset, which refers to the estimated timing of the asset’s benefits.

If an intangible asset is anticipated to provide benefits to the company firm for greater than one year, the proper accounting treatment would be to capitalize and expense it over its useful life.

The basis for doing so is based on the need to match the timing of the benefits along with the expenses under accrual accounting.

In the prior section, we went over intangible assets with definite useful lives, which should be amortized.

But there are two other classifications of intangibles.

1. Indefinite Intangible Assets ➝ The useful life is assumed to extend beyond the foreseeable future (e.g. land) and should NOT be amortized, but can be tested for potential impairment.
2. Goodwill ➝ Goodwill captures the excess of the purchase price over the fair market value (FMV) of an acquired company’s net identifiable assets. For public companies, goodwill should NOT be amortized, but is tested for potential impairment under GAAP accounting reporting standards.

Amortization of Intangible Assets Calculator — Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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1. Amortization Schedule Build

For our amortization schedule of intangible assets modeling tutorial, we’ll use the following assumptions:

• Beginning of Period Balance (Year 1) = $800k
• Purchases of Intangibles = $100k Per Year
• Useful Life of Intangibles = 10 Years

In the subsequent step, we’ll calculate annual amortization with our 10-year useful life assumption.

Upon dividing the additional $100k in intangibles acquired by the 10-year assumption, we arrive at $10k in incremental amortization expense.

However, since new acquisitions are done each period, we must track the coinciding amortization for each acquisition separately – which is the purpose of building the amortization waterfall schedule (and adding up the values at the bottom).

2. Amortization of Intangible Assets Calculation Example

Once our amortization schedule is filled out, we can link directly back to our intangible assets roll-forward.

However, we must ensure to flip the signs for the amortization to reflect a cash outflow (or else the model is inaccurate).

Considering the $100k purchase of intangibles each year, our hypothetical company’s ending balance expands from $890k to $1.25 million by the end of the ten-year forecast.

In closing, the amortization of the intangible assets grows in tandem with the consistent rise in purchases, with the total amortization expense increasing from $10k in Year 1 to $100k by the end of Year 10.