What is amortization versus depreciation of intangible assets?
Amortization and depreciation relate to the value of a company’s intangible assets, which are recorded in the balance sheet. Intangible assets include goodwill or the value associated with the name and reputation of the business. In addition, patents, trademarks and copyrights are valued and reported as intangible assets. As with any other asset, there is an estimated useful life and therefore depreciation over time. Depreciation is used to reflect the reduction in value of an intangible asset over its life. Depreciation occurs when an intangible asset is deemed less valuable than what is shown on the amortized balance sheet.
Key points to remember:
- Amortization and depreciation both relate to the value of a company’s intangible assets, which are recorded on the balance sheet.
- The concept of depreciation is to recognize the expenses associated with using the value of an intangible asset to generate income.
- With so many variables and inferences involved in determining the depreciation and life expectancy of an intangible asset, the cost of depreciation can be used to manipulate the balance sheet.
Understanding Depreciation Versus Depreciation of Intangible Assets
The concept behind depreciation is to recognize the expenses associated with using the value of an intangible asset to produce income. To determine depreciation, the company determines a present value of the intangible asset and defines its useful life, just like calculating depreciation. The annual amount is deducted each year from the balance sheet to reflect the present value of the asset. This is done by a debit entry to the depreciation expense account and a credit to the offsetting account which is carried forward to the balance sheet called accumulated depreciation. The amount is also shown in the income statement for each accounting period as an expense against operating profit, as well as taxes, interest and depreciation. The result is net income, which is used to determine earnings per share. For this reason, overestimating or underestimating the salvage value and useful life of the asset can have a huge impact on business results.
Impairment of intangible assets
As depreciation directly affects a company’s reported net income, this is an extremely important item for investors to assess. The new rules relating to generally accepted accounting principles (GAAP) require that the values ââof intangible assets be reassessed at least once a year. If it is determined that the fair value is less than the current valuation of the intangible asset less depreciation expense, the asset is considered to be impaired. If this is the case, the difference between the fair value and the present value is recorded as depreciation. This entry adjusts the intangible asset to fair market value on the balance sheet.
When a company acquires the assets of another company, the goodwill of the usurped company depreciates. In such a case, the cost of depreciation is deducted from the books of the new owner company to reduce the value of the asset to fair market value.
As long as a business manages depreciation costs responsibly, investors can see accurate valuations of the business.
With so many variables and inferences involved in determining the depreciation and life expectancy of an intangible asset, the cost of depreciation can be used to manipulate the balance sheet. One of the main factors contributing to manipulation is the fact that the declared values ââof intangibles do not have to be declared.