Amortization of Intangible Assets

Definition of Amortization of Intangible Assets

Amortization of intangible asset is a process under which the cost of an intangible asset is reduced over a specified period of time, also called as expected useful life. The general meaning of intangible is ‘without physical substance’. Intangibles are assets that may not have a physical substance but are still valuable resources for an entity.

Explanation

Like depreciation for tangible assets, amortization transfers part of the value of the intangible asset from the balance sheet to the income statement as a cost. Depreciation is done for tangible assets, and amortization is done for intangible assets.

Examples of Intangible assets are goodwill, patents, copyrights, trademarks.

How to Calculate Amortization of Intangible Assets

Accounting of an intangible asset depends upon its useful life, i.e. finite or indefinite. An intangible asset with a finite useful life is amortized while those with indefinite useful life are not amortized.

Amortization of an intangible asset begins when the asset is ready to use. Like depreciation, there are multiple methods available to calculate the amortization of an asset, but the simplest is the straight-line method.

The method for amortization selected should reflect the manner in which future economic benefits of the asset are expected to be consumed. If the company cannot determine that pattern reliably, the straight-line method should be used.

Steps to Calculate Amortization

• For calculating amortization under the straight-line method, we need three figures; the cost of an asset, residual value, if any, and its useful life.
• The cost of an asset is usually the price paid to acquire the asset. If an asset is created in house, the total cost incurred till the time it is ready to use.
• Residual value is its scrap value which is normally zero in the case of intangible assets.
• The useful life of an intangible asset is a period over which an asset is expected to be available for use by an entity.
• The formula to calculate amortization is (Cost of an asset – Residual value) / Useful life of the asset.
• After few years of using the asset, if the company finds out that the intangible asset is no longer useful for the company, it can straight away write off the asset from its books of accounts. The remaining cost of the asset will be booked as an expense in the Income statement, and the value of the asset will be zero.

Amortization of Intangible Assets Journal Entry

Amortization Calculated as Per the Straight Line Method Is Booked as An Expense Under Income Statement. in The Balance Sheet, the Balance of The Accumulated Amortization Account Will Be Increased Thereby Reducing the Net Cost of The Asset.

Below are the Journal entries booked for amortization of the asset:

Example of Amortization of Intangible Asset

Bharthi Ltd obtains a license with a finite useful life of 10 Years for $100 million. These rights are available for the next 10 years. After 10 years, the licences would need to go under the hammer, and the company would need to bid again for these licences.

The telecom operating licence is an intangible asset with a finite useful life of 10 years in the above case. Bharthi Ltd should recognize it as an intangible asset in its books and amortize it over a period of 10 years.

Using the straight-line method for amortization,

• Cost of the asset = $100 million
• Residual value = 0
• Useful life = 10 Years

Solution:

Amortization is calculated as

Amortization per Year = (Cost of the Asset – Residual Value) / Useful Life of Asset.

• Amortization = (100 – 0) / 10
• Amortization = $10 million

Advantages

Below are the few advantages of amortizing intangible assets:

• Amortization cost is recorded as an expense in the entity’s books of account, hence lower profits, leading to lesser taxes for the firm.
• Amortization helps assess the benefits of an intangible asset and how long those benefits will be available.
• Amortization helps to find the actual value of the asset for the business.

Limitations

Below are the few disadvantages of amortization of intangible assets:

• It is difficult to calculate the useful life of an intangible asset. If useful life is not correct, the amortizing cost would definitely be incorrect.
• Also, it is difficult to calculate the actual cost of intangible assets as they are not physical in nature.

Conclusion

Intangible assets are an important part of a company’s financial statement; hence it is very important to correctly measure and recognise these assets so that that true and fair value is shown in the books. Amortization helps to calculate the actual value of the asset for the business.

Recommended Articles

This is a guide to the Amortization of Intangible Assets. Here we also discuss the definition and how to calculate the amortization of intangible assets along with advantages and disadvantages. You may also have a look at the following articles to learn more –

1. Residual Value
2. Non-Cash Expenses
3. Balance Sheet Items
4. Funds from Operations