In business, amortization is the practice of writing down the value of an intangible asset,such as a copyright or patent, over its useful life. Amortization expenses can affect acompany’s income statement and balance sheet, as well as its tax liability.
Calculating amortization for accounting purposes is generally straightforward, although itcan be tricky to determine which intangible assets to amortize and then calculate theircorrect amortizable value. For tax purposes, amortization can result in significantdifferences between a company’s book income and its taxable income.
What is Amortization?
The term “amortization” may refer to two completely different financialprocesses: amortization of intangibles in business and amortization of loans.
For this article, we’re focusing on amortization as it relates to accounting andexpense management in business. In this usage, amortization is similar in concept todepreciation, the analogous accounting process. Depreciation is used for fixed tangibleassets such as machinery, while amortization is applied to intangible assets, such ascopyrights, patents and customer lists.
Loan amortization, a separate concept used in both the business and consumer worlds, refersto how loan repayments are divided between interest charges and reducing outstandingprincipal. Amortization schedules determine how each payment is split based on factors suchas the loan balance, interest rate and payment schedules.
Key Takeaways
- Amortization is the accounting process used to spread the cost of intangible assets overthe periods expected to benefit from their use.
- The customary method for amortization is the straight-line method.
- Determining which intangible assets may be amortized and the correct capitalized valuecan sometimes be tricky.
- Amortization rules differ significantly for tax versus book purposes. But appliedcorrectly, amortization can result in significant tax savings.
Amortization in Business
In business, accountants define amortization as a process that systematically reduces thevalue of an intangible asset over its useful life. It’s an example of the matching principle, oneof the basic tenets of Generally Accepted Accounting Principles (GAAP). The matchingprinciple requires expenses to be recognized in the same period as the revenue they helpgenerate, instead of when they are paid.
Amortization impacts a company’s income statement and balance sheet. It also has aunique set of rules for tax purposes and can significantly impact a company’s taxliability.
How is Amortization Calculated?
For book purposes, companies generally calculate amortization using the straight-line method.This method spreads the cost of the intangible asset evenly over all the accounting periodsthat will benefit from it.
The formula for amortization is:
CapitalizedCost = Annual amortization expense /Estimated useful life
Determining the capitalized cost of anintangible asset (the numerator in this equation) can be the trickiest part of thecalculation.
Say a company purchases an intangible asset, such as a patent for a new type of solar panel.The capitalized cost is the fair market value, based on what the company paid in cash, stockor other consideration, plus other incidental costs incurred to acquire the intangibleasset, such as legal fees.
Valuing intangible assets that were developed by your company is much more complex, becauseonly certain expenses can be included. Say you develop patentable new solar technologyinternally. Only the costs to secure the patent, such as legal, registration and defensefees, can be amortized. The costs incurred to develop the technology, such as R&Dfacilities and your engineers’ salaries, are deductible as business expenses.
For tax purposes, there are even more specific rules governing the types of expenses thatcompanies can capitalize and amortize as intangible assets, as we’ll discuss.
Calculating and maintaining supporting amortization schedules for both book and tax purposescan be complicated. Using accounting software to manageintangible asset inventory and perform these calculations will make the process simpler foryour finance team and limit the potential for error.
Video: Amortization Defined
Amortization of Intangibles
Amortization applies to intangible assets with an identifiable useful life—thedenominator inthe amortization formula. The useful life, for book amortization purposes, is theasset’s economic life (the expected period during which an asset is useful to theowner) or its contractual/legal life (the time until, for example, a patent or licenseexpires), whichever is shorter.
Limiting factors such as regulatory issues, obsolescence or other market factors can make anasset’s economic life shorter than its contractual or legal life.
Examples of amortizable intangible assets include:
- Patents
- Copyrights
- Franchises
- Trademarks
- Software developed for internal use (not sold to customers)
- Customer lists
- Licenses
In contrast, intangible assets that have indefinite useful lives, such as goodwill,are generally not amortized for book purposes, according to GAAP. Instead, they areperiodically reviewed to determine whether their value has decreased—this is known as“impairment of value.” Companies record any write-down as a loss on the P&L,not as an amortization expense.
There are some limited exceptions to this rule that allow privately held businesses to amortizegoodwill over a 10 year period.
A company’s intangible assets are disclosed in the long-term asset section of itsbalance sheet, while amortization expenses are listed on the income statement, or P&L.However, because amortization is a non-cash expense, it’s not included in acompany’s cash flow statement or in some profit metrics, such asearnings before interest, taxes, depreciation and amortization (EBITDA).
Amortization for Tax Purposes
The IRS may require companies to apply different useful lives to intangible assets whencalculating amortization for taxes. This variation can result in significant differencesbetween the amortization expense recorded on the company’s book and the figure usedfor tax purposes.
The IRS calls the assets in the list above, such as patents and trademarks, “Section 197” intangibles after thesection of the tax code where they’re defined. It requires companies to apply a15-year useful life when calculating amortization for these assets for tax purposes.
Intangible assets that are outside this IRS category are amortized over differing usefullives, depending on their nature. For example, computer software that’s readilyavailable for purchase by the general public is not considered a Section 197 intangible, andthe IRSsuggests amortizing it over a useful life of 36 months.
One notable difference between book and amortization is the treatment of goodwillthat’s obtained as part of an asset acquisition. IRS publication 535,which covers business expenses, allows companies to use straight-line amortization ofgoodwill over a period of 180 months for tax purposes, whereas they must use the“impairment of value” measure to determine any amortization loss for bookpurposes.
Example of Amortization
Many examples of amortization in business relate to intellectual property, such as patentsand copyrights. Here’s a typical situation.
- Company ABZ Inc. paid an outside inventor $180,000 for the exclusive rights to a solarpanel she developed.
- ABZ Inc. spent $20,000 to register the patent, transferring the rights from the inventorfor 20 years.
- News of the sale caused two other inventors to challenge the application of the patent.ABZ successfully defended the patent but incurred legal fees of $50,000.
Patent capitalizedcost = $250,000 ($180,000 + $20,000 +$50,000)
Usefullife = 20 years
$250,000 / 20 = $12,500 annual amortization expense
Free Amortization Work Sheet
Download our free work sheet to apply amortization to intangible assets likepatents and copyrights.
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Amortization vs. Depreciation: What's the Difference?
Amortization and depreciation are similar in that they both support the GAAP matchingprinciple of recognizing expenses in the same period as the revenue they help generate.
However, there are significant differences between them.
- Intangible vs. tangible assets: Amortization is used for intangibleassets, while depreciation is used for tangible, fixed assets such as office equipmentor buildings.
- Cause of reduced asset value: Amortization generally reflects anintangible asset’s loss in value due to circ*mstances like contract expiration orobsolescence. In contrast, depreciation reflects the fact that a fixed asset loses valueas it wears out or becomes consumed.
- Applicability: Amortization applies only to intangible assets withfinite, identifiable useful lives and not those with indefinite useful lives, whiledepreciation is generated for every fixed asset, excluding land.
- Salvage value: Amortization is most often calculated on the entirevalue of an intangible asset, while depreciation typically assumes that a fixed assethas a salvage value.
- Journal entries: Amortization expense is charged (debited) to theP&L expense account with an offsetting credit directly in the intangible assetaccount. In contrast, depreciation is credited to accumulated depreciation, acontra-asset account.
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Amortizing Startup Costs
Entrepreneurs often incur startup costs to organize a business before it begins operating.These startup costs may include legal and consulting fees as well as marketing expenses andare an example of an area where there’s a significant difference between bookamortization and tax amortization.
Under GAAP, for book purposes, any startup costs are expensed as part of the P&L; theyare not capitalized into an intangible asset.
For tax purposes, however, some startup and organizational costs may be capitalized andamortized over periods up to 15 years, after taking initial deductions in the first year ofoperations. Determining which payments can be capitalized, and maintaining the associatedadditional amortization schedules, can be a tedious process. If a company hasn’talready implemented a robustaccounting system as part of its startup efforts, additional bookkeeping expertise may be needed.
