How to calculate the amortization of intangible assets

0

Image source: Getty Images

Accountants depreciate intangible assets as they depreciate physical assets.

Intangible assets are non-physical assets listed on a company’s balance sheet. These may include patents, intellectual property, trademarks and goodwill. Intangible assets can 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 just from use, their intangible counterparts wear out due to contract expirations, obsolescence, and other non-physical factors.

If an intangible asset has a finite life, the company 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 records an expense in the income statement of each period to reflect the change in the balance sheet during the given period.

Like depreciation, there are several methods a business can use to calculate the depreciation of an intangible asset, but the simplest is the straight-line method.

With the linear method, the company starts from the recorded value of the asset, its residual value and its useful life.

The recorded value is the original value assigned 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, the 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 company expects the intangible asset to provide economic value to the company.

The mechanics of the calculation of the depreciation is in addition the same as that of the calculation of the depreciation with the linear method. The company should subtract the residual value from the recorded cost and then divide this 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 “depreciation charge”.

An example of calculating the amortization of an intangible asset

Let’s say a company has developed a software solution to use 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 any residual value, so its residual value is zero.

The company will use the straight-line method to report software amortization.

By subtracting the residual value – zero – from the recorded cost of $10,000, then dividing by the three-year useful life of the software, the company’s accountants determine the annual depreciation of the software at $3,333.

Each year, the net asset value of the software will decrease 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

Depreciation expense

Saved cost

Accumulated depreciation

Net asset value

Year 0-Purchase

$3,333

$10,000

$0

$10,000

Year 1

$3,333

$10,000

$3,333

$6,667

Year 2

$3,333

$10,000

$6,667

$3,333

Year 3

$3,333

$10,000

$10,000

$0

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 intangible assets however, it is much more common to have an asset that does not need to be amortized.

This stems from the fact that more intangible assets have indefinite useful lives than physical assets.

If an intangible asset continues to provide economic value without deteriorating over time, it should not be amortized. Instead, its value should be reviewed periodically and adjusted with depreciation.

Goodwill, for example, is an intangible asset that never needs to be amortized.

If goodwill needs to be modified, it should be done through the process of impairment, where the value of the asset is changed based on specific, changing conditions rather than on a calculated schedule as it would be. 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 where the purchase price exceeds the fair market value of assets and liabilities.

Share.

Comments are closed.