Title: Amortization of Intangibles — what it is, how to compute it, and where it appears in the accounts
Definition
– Amortization of intangibles is the planned allocation of an intangible asset’s cost to expense over its useful life for accounting or tax reporting. An intangible asset is a nonphysical item that has economic value, for example patents, trademarks, and franchise rights.
Why companies amortize
– To match the expense of an asset to the revenues it helps generate in the same accounting periods, in line with generally accepted accounting principles (GAAP).
– To reflect the consumption of the asset’s value over time on financial statements and tax returns.
Key differences versus depreciation
– Depreciation applies to tangible (physical) assets and commonly considers a salvage value (the expected residual value at the end of useful life).
– Amortization applies to intangible assets and generally does not include a salvage value—cost is typically spread across the asset’s useful life.
Which intangibles and tax rules to note
– Many purchased intangibles (patents, trademarks, goodwill, trade names) fall under Internal Revenue Code “Section 197”; the IRS generally authorizes amortizing Section 197 intangibles over 15 years for tax purposes.
– Certain software and other unique items may be treated under different IRS rules (for example, Section 167) and have different tax amortization treatments.
– For tax filings, amortization is reported on IRS Form
4562 (Depreciation and Amortization). For tax purposes, businesses summarize depreciation and amortization deductions on Form 4562 and attach it to the income tax return for the year when the deduction begins.
Practical points and special cases
– Purchased versus internally developed. Purchased intangibles (for example, a patent bought from a third party) are capitalized and amortized. Internally developed intangibles (for example, R&D costs) are usually expensed as incurred for accounting or treated differently for tax purposes; capitalization rules vary by jurisdiction and specific circumstances. Always check the relevant accounting standard and tax code.
– Indefinite-lived intangibles. Assets presumed to have an indefinite useful life—commonly certain trademarks or goodwill—are not amortized. Instead, they are tested periodically for impairment (see the impairment section below). If an indefinite life later becomes finite, begin amortization from that point over the revised useful life.
– Goodwill. Under U.S. GAAP and IFRS, goodwill arising on a business combination is generally not amortized; it is tested for impairment at least annually. Tax rules differ: some jurisdictions (including the U.S. for many purchased intangibles under Section 197) allow amortization for tax purposes even when financial reporting does not.
– Tax amortization (Section 197 in the U.S.). Many purchased intangibles are treated under Internal Revenue Code Section 197, which requires straight-line amortization over 15 years (180 months) for U.S. federal tax. Amortization begins in the month the intangible is acquired and is prorated by month in the first year.
How to calculate straight-line amortization (step-by-step)
1. Determine the capitalized cost. Include purchase price and directly attributable costs to prepare the asset for use (legal fees, registration costs, etc.). Exclude ongoing operating costs.
2. Estimate the useful
life (the period over which the asset is expected to contribute to cash flows). Use reasonable, supportable assumptions (contracts, legal life, industry practice). If the economic benefits are expected to be indefinite, classify the intangible as indefinite‑lived and do not amortize (instead test for impairment at least annually).
3. Determine residual (salvage) value. For most intangibles the residual value is zero because there is little expected recovery value; if there is an expected disposition value, subtract it from the capitalized cost.
4. Choose the amortization method. The most common is straight‑line: equal expense each period. If consumption of benefits is uneven and measurable, use a systematic method that reflects benefit pattern (units‑of‑production, etc.). Disclose the method used.
5. Compute the periodic amortization amount.
– Annual straight‑line amortization = (Capitalized cost − Residual value) / Useful life (years).
– Monthly amortization = (Capitalized cost − Residual value) / Useful life (months).
– For tax rules like U.S. IRC Section 197 (15‑year straight line): Monthly tax amortization = Cost / 180 months; prorate months in the acquisition month.
6. Record the amortization. Typical journal entry each period:
– Debit: Amortization expense (income statement)
– Credit: Accumulated amortization — intangible (contra‑asset on balance sheet)
Keep a schedule showing opening balance, additions, expense, disposals, and closing balance.
Worked numeric examples
Example A — Financial reporting (GAAP-style) straight line
– Purchased patent and related legal fees: purchase price $120,000 + legal $5,000 = capitalized cost $125,000.
– Estimated useful life: 5 years. Residual value: $0.
– Annual amortization = 125,000 / 5 = $25,000.
– Journal (each year): Dr Amortization expense $25,000; Cr Accumulated amortization — patent $25,000.
Example B — U.S. tax (Section 197) monthly proration
– Same asset capitalized cost: $125,000. Section 197 amortization period: 15 years = 180 months.
– Monthly tax amortization = 125,000 / 180 = $694.44 (rounded).
– If acquired April 15 and amortization begins in the acquisition month, months in year 1 = 9 (Apr–Dec).
– Year 1 tax deduction = 694.44 × 9 = $6,250.00 (rounded).
– Thereafter, full 12‑month amounts until disposal.
Checklist before you record amortization
– Confirm asset meets recognition criteria and costs capitalized.
– Document cost components and supporting invoices.
– Determine useful life and residual value with supporting rationale.
– Select amortization method and document why it reflects benefit pattern.
– For purchased intangibles in the U.S., check whether Section 197 applies (most purchased intangibles) and compute tax amortization separately.
– Prepare amortization schedule and post consistent journal entries each period.
– Review annually for impairment indicators; indefinite‑lived intangibles need annual impairment testing.
Key practical notes and assumptions
– Estimates matter: useful life and residual value are judgments. Changes in estimate are accounted for prospectively.
– Indefinite‑lived intangibles are not amortized but must be tested for impairment at least annually.
– Tax amortization rules can require different lives and start dates than accounting amortization; maintain parallel schedules for tax filings.
– Disclose amortization method, useful lives, and aggregate amortization in financial statement notes.
Example journal entries (concise)
– On acquisition (capitalization): Dr Intangible asset $125,000; Cr Cash/AP $125,000.
– Monthly amortization (straight line, 5‑yr example): Dr Amortization expense $2,083.33; Cr Accumulated amortization $2,083.33.
Sources for further reading
– Investopedia — “Amortization of Intangibles”: https://www.investopedia.com/terms/a/amortization-of-intangibles.asp
– Cornell Legal Information Institute — 26 U.S. Code § 197 (Amortization of goodwill and certain intangible property): https://www.law.cornell.edu/uscode/text/26/197
– Financial
Financial Accounting Standards Board (FASB) — ASC Topic 350, “Intangibles—Goodwill and Other” (overview): https://www.fasb.org/home
International Accounting Standards Board (IASB) — IAS 38, Intangible Assets: https://www.ifrs.org/issued-standards/list-of-standards/ias-38-intangible-assets/
Deloitte
— Deloitte — “Accounting for Intangibles and Goodwill” (insight overview): https://www2.deloitte.com/global/en/pages/audit/articles/accounting-for-intangibles-and-goodwill.html
Practical checklist for accounting teams
– Confirm capitalization: document the contract or transaction giving rise to the intangible, assess identifiability (separable or arising from contractual/legal rights), and confirm the entity controls future economic benefits.
– Classify useful life: determine if the asset has a finite life (amortize) or an indefinite life (do not amortize; test for impairment annually).
– Choose amortization method: select the systematic pattern that reflects consumption of benefits (straight-line is common). If pattern cannot be reliably estimated, use straight-line.
– Set start and end dates: amortization normally begins when the asset is available for use. Record the useful life and expected residual value (often zero).
– Compute and post entries: prepare schedules (monthly/annual) showing expense, accumulated amortization, and carrying amount.
– Maintain tax schedule: maintain a separate tax amortization schedule if tax rules (for example, US tax Code §197) prescribe different lives or start dates.
– Monitor for impairment triggers: document events/changes in circumstances (market, technology, legal) and perform impairment tests as required.
– Disclose: method, useful lives, aggregate amortization, carrying amounts, and impairment losses in notes.
Common mistakes to avoid
– Capitalizing preliminary research costs that should be expensed (especially for internally generated intangibles).
– Using an arbitrarily long useful life without support from forecasts or technical life assessments.
– Forgetting to maintain separate tax amortization records—tax and accounting treatments often diverge.
– Omitting periodic impairment assessments for indefinite-lived intangibles.
– Poor documentation of assumptions (discount rates, cash-flow projections) used in impairment tests.
Worked numeric example (extends the prior monthly amortization numbers)
Assumptions
– Cost at acquisition: $125,000
– Useful life: 5 years (finite)
– Residual value: $0
– Amortization method: straight-line
– Amortization frequency: monthly
Calculations
– Annual amortization expense = 125,000 / 5 = 25,000.
– Monthly amortization expense = 25,000 / 12 = 2,083.33.
Key amounts after certain periods
– Accumulated amortization after 12 months = 25,000.
– Carrying amount after 12 months = 125,000 − 25,000 = 100,000.
– Accumulated amortization after 36 months = 75,000.
– Carrying amount after 36 months = 50,000.
Example: impairment event after 36 months
– Suppose an impairment test indicates recoverable amount = 40,000.
– Carrying amount before impairment = 50,000.
– Impairment loss = 50,000 − 40,000 = 10,000.
Concise journal entry (illustrative)
– Dr Impairment loss 10,000; Cr Intangible asset 10,000.
Notes: Under some frameworks you may credit accumulated amortization instead—follow applicable GAAP/IFRS guidance and company policy.
Quick reference formulas
– Annual amortization (straight-line) = (Cost − Residual value) / Useful life (years).
– Carrying amount at time t = Cost − Accumulated amortization at t.
– Accumulated amortization at t (years) = Annual amortization × t (for full-year t).
Assumptions and scope notes
– These instructions assume finite-lived intangibles measured under typical accrual accounting. Rules differ for indefinite-lived intangibles (no amortization) and for tax reporting. Impairment tests require judgement and sometimes discounted cashflow models; always follow your applicable GAAP/IFRS standard for measurement and disclosure specifics.
Further reading (authoritative sources)
– Investopedia — Amortization of Intangibles: https://www.investopedia.com/terms/a/amortization-of-intangibles.asp
– Cornell Legal Information Institute — 26 U.S. Code § 197 (Amortization of goodwill and certain intangible property): https://www.law.cornell.edu/uscode/text/26/197
– FASB — ASC Topic 350, “Intangibles—Goodwill and Other” (overview): https://www.fasb.org/home
– IASB — IAS 38, Intangible Assets: https://www.ifrs.org/issued-standards/list-of-standards/ias-38-intangible-assets/
– Deloitte — Accounting for Intangibles and Goodwill (insight overview): https://www2.deloitte.com/global/en/pages/audit/articles/accounting-for-intangibles-and-goodwill.html
Educational disclaimer
This response is for general educational purposes only and does not constitute professional accounting, tax, or investment advice. For decisions affecting financial statements or tax filings, consult a qualified accountant, auditor, or tax advisor