Intangible assets are non-physical assets shown on a company’s balance sheet. These can be patents, intellectual property, trademarks and goodwill. Intangibles could even be as simple as a customer list or a franchise agreement.
Some of these intangible assets have a limited useful life.
While physical assets can wear out over time and lose value simply through use, their intangible counterparts wear out through contract expiration, obsolescence, and other non-physical factors. .
If an intangible asset has a finite useful life, the business is required to depreciate it, a process very similar to how physical assets are depreciated over time.
What does depreciation actually mean?
The amortization process in accounting reduces the value of the intangible asset on the balance sheet over time and reports an expense to the income statement each period to reflect the change in the balance sheet during the given period.
Like depreciation, there are several methods that a business can use to calculate the depreciation of an intangible asset, but the simplest is the straight-line method.
With the straight-line method, the business begins with the recorded value of the asset, its residual value and its useful life.
The recorded value is the initial value attributed to the asset on the books, i.e. usually its price or cost of creation.
Its residual value is the expected value of the asset at the end of its useful life.
For most intangible assets, residual value is zero because many intangible assets are considered worthless once they have been fully utilized.
The useful life of the asset is the period during which the business expects the intangible asset to provide economic value to the business.
The mechanics of the calculation of damping is also the same as that of the calculation of damping with the linear method. The business must subtract the residual value from the recorded cost and then divide that difference by the useful life of the asset.
Each year, this value will be deducted from the cost recorded on the balance sheet in an account called “accumulated depreciation”, reducing the value of the asset each year. The income statement will show the reduction each year as a âdepreciation chargeâ.
An example of calculating the amortization of an intangible asset
Let’s say that a company has developed a software solution to be used internally to better manage its inventory.
The company does not intend to sell this software; it should only be used by company personnel. This software is considered an intangible asset and must be amortized over its useful life.
First, the company will record the cost of creating the software on its balance sheet as an intangible asset. The software cost the company $ 10,000 in this case.
Next, the company estimates that the software will have a useful life of only three years given the rapid nature of software innovation.
After three years, the company estimates that its internal software will no longer have residual value, so its residual value is zero.
The company will use the straight-line method to report software depreciation.
By subtracting the residual value – zero – from the recorded cost of $ 10,000, then dividing by the software’s three-year useful life, the company’s accountants determine the software’s annual depreciation at $ 3,333.
Each year, the net asset value of the software will be reduced by this amount and the company will report $ 3,333 in depreciation expense.
Here is a breakdown of how the balance sheet and income statement will reflect this amortization over the three year period.
When intangible assets should not be amortized
Most physical assets will depreciate over time.
Land is one of the few examples where a physical asset should never be depreciated. For intangibles, however, it is much more common to have an asset than not to be depreciated.
This follows from the fact that more intangible assets have an indefinite useful life than physical assets.
If an intangible asset continues to provide economic value without deterioration over time, it should not be amortized. Instead, its value should be periodically reviewed and adjusted with depreciation.
Goodwill, for example, is an intangible asset that should never be amortized.
If goodwill needs to be changed, this should happen through the impairment process, where the value of the asset is changed based on specific and changing conditions rather than on the basis of a calculated schedule as would be the case. with depreciation.
Goodwill is the part of a company’s value that is not attributable to other assets. Goodwill is a current result of acquisitions for which the purchase price is greater than the fair market value of the assets and liabilities.