Amortization of Intangibles

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What Is the Amortization of Intangibles?

Amortization of intangibles is the process of expensing the cost of an intangible asset over the projected life of the asset for tax or accounting purposes. The amortization process for corporate accounting purposes may differ from the amount of amortization posted for tax purposes.

Intangible assets, such as patents and trademarks, are amortized into an expense account. Tangible assets are instead written off through depreciation.

Key Takeaways

  • Amortization of intangible assets is a process by which the cost of such an asset is incrementally expensed or written off over time.
  • Amortization applies to intangible (non-physical) assets, while depreciation applies to tangible (physical) assets.
  • Intangible assets may include patents, goodwill, trademarks, and human capital.

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. In the years in which the asset is either acquired and sold, the amount of amortization deductible for tax purposes is pro-rated on a monthly basis. Intangible amortization is reported to the IRS using Form 4562.1

Intangible assets are non-physical assets that can be assigned an economic value. According to Section 197 of the Internal Revenue Code (IRC), there are numerous qualifying intangible assets, but the most common are patents, goodwill, the value of a worker’s knowledge, trademarks, trade and franchise names, noncompetitive agreements related to business acquisitions, and a company’s human capital.2

Intellectual property (IP), for instance, is considered to be an intangible asset, but which can have great value. Intellectual property includes patents, copyrights, and trademarks. When a parent company purchases a subsidiary company and pays more than the fair market value 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 as 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. When businesses amortize expenses over time, they help tie the cost of using an intangible asset to the revenues it generates in the same accounting period, in accordance with generally accepted accounting principles (GAAP).

Amortization vs. Depreciation

Assets are used by businesses to generate revenue and produce net income. Over a period of time, the costs related to the assets are moved into an expense account. By recognizing an expense for the cost of the asset, the company is complying with Generally Accepted Accounting Principles (GAAP) which require 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.

Example of Depreciation and Amortization

Assume, for example, that a carpenter uses a $32,000 truck to perform residential carpentry 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 divided by eight years, or $4,000 per year.

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 $10,000 of 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.

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