Amortization of Intangibles

What Is the Amortization of Intangibles?

Amortization of intangibles, also simply known as amortization, is the process of expensing the cost of an intangible asset over the projected life of the asset for tax or accounting purposes. Intangible assets, such as patents and trademarks, are amortized into an expense account called amortization. Tangible assets are instead written off through depreciation. The amortization process for corporate accounting purposes may differ from the amount of amortization used for tax purposes.

Understanding Amortization of Intangibles

For tax purposes, the cost basis of an intangible asset is amortized over a specific number of years, regardless of the actual useful life of the asset (as most intangibles don't have a set useful life). The Internal Revenue Service (IRS) allows intangibles to be amortized over a 15-year period if it's one of the ones included in Section 197.

Intangible assets are non-physical assets that can be assigned an economic value. Intellectual property (IP) is considered to be an intangible asset and is a broad term that encompasses most intangible assets. Most IP is covered under Section 197. Examples of these Section 197 intangible assets include patents, goodwill, trademarks, and trade and franchise names.

Not all IP is amortized over the 15-year period set by the IRS, however. There are certain exclusions, such as software acquired in a transaction that is readily available for purchase by the general public, subject to a nonexclusive license, and has not been substantially modified. In those cases and select others, the intangibles are amortized under Section 167.

Per GAAP, businesses amortize intangibles over time to help tie the cost of an asset to the revenues it generates in the same accounting period.

Special Considerations

When a parent company purchases a subsidiary company and pays more than the fair market value (FMV) of the subsidiary's net assets, the amount over fair market value is posted to goodwill (an intangible asset). IP is initially posted as an asset on the firm's balance sheet when it is purchased.

IP can also be internally generated by a company's own research and development (R&D) efforts. For instance, a company may win a patent for a newly developed process, which has some value. That value, in turn, increases the value of the company and so must be recorded appropriately.

In either case, the process of amortization allows the company to write off annually a part of the value of that intangible asset according to a defined schedule.

Amortization vs. Depreciation

Assets are used by businesses to generate revenue and produce income. Over a period of time, the costs related to the assets are moved into an expense account as the useful life of the asset dwindles. By expensing the cost of the asset over a period of time, the company is complying with generally accepted accounting principles (GAAP), which requires the matching of revenue with the expense incurred to generate the revenue.

Tangible assets are expensed using depreciation, and intangible assets are expensed through amortization. Depreciation generally includes a salvage value for the physical asset — the value that the asset can be sold for at the end of its useful life. Amortization doesn't take into account a salvage value.

Intangible amortization is reported to the IRS using Form 4562.

Types of Amortization

For accounting (financial statement) purposes, a company can choose from six amortization methods — straight line, declining balance, annuity, bullet, balloon, and negative amortization. There are only four depreciation methods that can be used for accounting purposes — straight line, declining balance, sum-of-the-years' digits, and units of production.

For tax purposes, there are two options for amortization of intangibles that the IRS allows — straight line and the income forecast method. The income forecast method can be used instead of the straight-line method if the asset is: motion picture films, videotapes, sound recordings, copyrights, books, or patents. For depreciation of physical assets, the IRS only allows the Modified Accelerated Cost Recovery System (MACRS).

Example of Amortization

Assume, for example, that a construction company buys a $32,000 truck to contractor work, and that the truck has a useful life of eight years. The annual depreciation expense on a straight-line basis is the $32,000 cost basis minus the expected salvage value — in this case, $4,000 — divided by eight years. The annual deprecation for the truck would be $3,500 per year, or ($32,000 - $4,000) / 8.

On the other hand, assume that a corporation pays $300,000 for a patent that allows the firm exclusive rights over the intellectual property for 30 years. The firm's accounting department posts a $10,000 amortization expense each year for 30 years.

Both the truck and the patent are used to generate revenue and profit over a particular number of years. Since the truck is a physical asset, depreciation is used, and since the rights are intangible, amortization is used.