The Amortization of Intangible Assets is the accounting process whereby 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.
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The amortization of intangible assets is defined as the systematic process of allocating the cost of an intangible asset over its useful life.
Intangible assets are non-physical assets that create value on behalf of a company for a period in excess of 12 months, such as patents, trademarks, and copyrights.
Under U.S. GAAP reporting standards, the recognition of the amortization expense is necessary to ensure the timing of the expense is matched with the coinciding revenue.
Therefore, public companies must adhere to the matching principle in accounting by recording the entire expense on the income statement.
The useful life of an intangible asset refers to the period over which the underlying intangible asset is anticipated to provide positive economic benefits to the company — however, the useful life is merely an estimation based on a multitude of factors.
Ultimately, historical precedence and management judgment dictates the useful life assumption.
Note: The term “amortization” can also refer to the reduction of the principal on the subject of lending.
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)
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.
Amortization Expense = (Historical Cost of Intangible Asset – Residual Value) ÷ Useful LifeThe 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.
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.
We’ll now move to a modeling exercise, which you can access by filling out the form below.
For our amortization schedule of intangible assets modeling tutorial, we’ll use the following assumptions:
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 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.
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