What is amortization of intangible assets?
Amortization of intangible assets, also simply referred to as amortization, is the process of expensing the cost of an intangible asset over the expected life of the asset for tax or accounting purposes. Intangible assets, such as patents and trademarks, are amortized in an expense account called amortization. Rather, tangible fixed assets are depreciated by depreciation. The depreciation process for business accounting purposes may differ from the depreciation amount used for tax purposes.
Key points to remember
- Amortization of intangible assets is a process by which the cost of such an asset is gradually expensed or amortized over time.
- Depreciation applies to intangible (non-physical) assets, while depreciation applies to tangible (physical) assets.
- Intangible assets can include various types of intellectual property: patents, goodwill, trademarks, etc.
- Most intangible assets must be amortized over 15 years for tax purposes.
- For accounting purposes, there are six depreciation methods: straight line, declining balance, annuity, lump sum depreciation, balloon, and negative depreciation.
Understanding the amortization of intangible assets
For tax purposes, the base cost of an intangible asset is amortized over a specific number of years, regardless of the actual useful life of the asset (because most intangible assets have no defined utility). The Internal Revenue Service (IRS) allows amortization of intangible assets over a period of 15 years if it is one of those included in section 197.
Intangible assets are non-physical assets that can be attributed an economic value. Intellectual property (IP) is considered an intangible asset and is a general term that encompasses most intangible assets. Most IP is covered by Section 197. Examples of these Section 197 intangibles include patents, goodwill, trademarks, and trade and franchise names.
However, not all PI is amortized over the 15-year period set by the IRS. There are certain exclusions, such as software acquired as part of a transaction which is readily available for purchase by the general public, is subject to a non-exclusive license, and has not been substantially modified. In these and other cases, intangible assets are amortized under section 167.
Under GAAP, companies amortize intangible assets over time to help link the cost of an asset to the revenue it generates during the same accounting period.
When a parent company purchases a subsidiary and pays more than the fair market value (FMV) of the net assets of the subsidiary, the amount in excess of the fair market value is recognized as goodwill (an intangible asset). Intellectual property is initially recorded as an asset on the company’s balance sheet when it is acquired.
Intellectual property can also be generated internally through a company’s own research and development (R&D) efforts. For example, a company can obtain a patent for a newly developed process, which has a certain value. This value, in turn, increases the value of the business and therefore needs to be recorded appropriately.
In both cases, the amortization process allows the company to annually amortize a portion of the value of this intangible asset according to a defined schedule.
Amortization vs depreciation
Assets are used by businesses to generate income and produce income. Over time, the costs of the assets are transferred to an expense account as the useful life of the asset decreases. By expensing the cost of the asset over a period of time, the business complies with generally accepted accounting principles (GAAP), which require the matching of income with the expenses incurred to generate the income.
Property, plant and equipment are expensed through amortization and intangible assets are expensed through amortization. Depreciation generally includes a salvage value for the physical asset, that is, the value at which the asset can be sold at the end of its useful life. Depreciation does not take into account a salvage value.
Intangible amortization is reported to the IRS using Form 4562.
Types of amortization
For accounting purposes (financial statements), a company can choose from six depreciation methods: straight line, declining balance, annuity, in fine, balloon and negative depreciation. There are only four depreciation methods that can be used for accounting purposes: straight line, declining balance, sum of years figures, and units of production.
For tax purposes, there are two options for amortizing intangibles that the IRS allows: the straight line and the income forecast method. The forecast revenue method can be used instead of the linear method if the asset is: motion pictures, video tapes, sound recordings, copyrights, books or patents. For depreciation of physical assets, the IRS only allows the Modified Accelerated Cost Recovery System (MACRS).
Suppose, for example, that a construction company purchases a truck for $ 32,000 from a contractor and the truck has a useful life of eight years. The annual depreciation expense on a straight-line basis is the base cost of $ 32,000 less the expected salvage value – in this case, $ 4,000 – divided by eight years. The annual depreciation of the truck would be $ 3,500 per year, or ($ 32,000 – $ 4,000) / 8.
On the other hand, suppose a company pays $ 300,000 for a patent that gives it exclusive intellectual property rights for 30 years. The firm’s accounting department records depreciation expense of $ 10,000 each year for 30 years.
The truck and the patent are used to generate income and profit over a number of years. Since the truck is a physical asset, depreciation is used, and since rights are intangible, depreciation is used.