What is the Amortization of Intangible Assets?
The Amortization of Intangible Assets is the process in which purchases of non-physical intangibles are incrementally expensed across their appropriate useful life assumptions.
Conceptually, the amortization of intangible assets is identical to the depreciation of fixed assets like PP&E, with the non-physical nature of intangible assets being the main distinction.
- What are the distinct characteristics of intangible assets?
- How does the amortization of intangibles differ from the depreciation of fixed assets?
- How does accrual accounting determine whether to expense or capitalize certain items?
- What is an amortization schedule of intangible assets used to measure?
Table of Contents
Amortization of Intangible Assets Overview
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.
|Examples of Intangible Assets|
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).
IRS Section 197 – Intangible Assets
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 vs Depreciation Expense
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”.
As for the balance sheet, the amortization expense reduces the appropriate intangible assets line item – or in one-time cases, items such as goodwill impairment can affect the balance.
Capitalized vs Expensed Accounting Treatment
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.
- 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.
- Goodwill – Goodwill captures the excess of the purchase price over the fair market value (FMV) of an acquired company’s net identifiable assets – goodwill for public companies should NOT be amortized (but under GAAP accounting, is tested for potential impairment).
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.
Straight-Line Amortization Formula
- Amortization Expense = (Historical Cost of Intangible Asset – Residual Value) / Useful Life Assumption
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).
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.
Example Calculation of Intangible Assets Amortization
For our amortization modeling tutorial, use the following assumptions:
Intangible Assets 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).
Once the amortization schedule is filled out, we can link directly back to our intangible assets roll-forward, but we must ensure to flip the signs to indicate how amortization is a cash outflow.
Considering the $100k purchase of intangibles each year, our hypothetical company’s ending balance expands from $890k to $1.25mm by the end of the 10-year forecast.
As a result, the amortization of intangible assets grows in tandem with the consistent increase in purchases – with the total amortization increasing from $10k in Year 1 to $100k by the end of Year 10.