Amortization of Intangible Assets Defined
An intangible asset is not physical but has a useful life that exceeds a year. Intangible assets include computer software, trademarks, franchise agreements, motion pictures, and customer lists.
For tax and accounting purposes, this asset’s value gets expensed or amortized throughout their useful life. The amortization for accounting could differ from the measure of amortization put for taxation. Intangible assets get amortized into an account for expenditures, whereas, tangible assets get set to expenses through depreciation.
A Little More on Amortization of Intangibles
Intangible assets have to be amortized as long as they add to earnings. In taxation, the original value of an intangible asset decreases over a specific period, no matter the asset’s actual useful life. When the asset gets sold, the taxable amortization amount gets taken out on a prorated monthly basis.
Intangible assets usually are not a physical good nor efficiently priced or assigned value. There are many qualifying intangible assets, but the most popular ones include:
- noncompetitive agreements as they relate to business acquisitions
- franchise and trade names
- value of acquired knowledge for a worker
- a business’ human capital or quantified economic value of workers’ skills
Patents and copyrights are intellectual property and considered intangible assets. Any amount over the fair market value of a purchased subsidiary company’s net assets gets posted to another intangible asset, goodwill. Accountants list the intellectual property as an asset on the subsidiary’s balance sheet when it gets bought by a parent company.
A company uses assets to produce net income and generate revenue, which as time goes by, the cost of the assets eventually get moved int an expense account. Making the cost of an asset an expense is the company’s way of matching revenue with the expense brought about when generating revenue. Intangible assets get expensed with amortization, whereas, tangible assets get charged using depreciation.
Let’s use, for example, a moving company uses a $50,000 truck to move property from one place to another, and the vehicle has a useful life of 10 years. On a straight-line basis, the annual depreciation expense is the $50,000 cost divided by 10 years, which is $5,000 each year.
Now if the asset to be accounted for is a trademark a company pays $200,000 to keep exclusive intellectual property rights for 40 years, the corporation will post a $5,000 of amortization expense over the 40 years. The trademark and the truck both help to generate profit and revenue for their respective business over a specific length of time.
References for Amortization of Intangibles
Academic Research on Amortization of Intangibles
Amortization of Intangibles: A Reassessment of the Tax Treatment of Purchased Goodwill, Gregorcich, M. J. (1975). Amortization of Intangibles: A Reassessment of the Tax Treatment of Purchased Goodwill. The Tax Lawyer, 251-288. Gregorcich says that since prohibition, goodwill has been amortizable. However, the authors believe that amortizing intangibles, regardless of their undefined useful life, should now be considered. In the 1960s, intangibles, including goodwill were reconsidered for accounting purposes. Gregorcich feels laws in place regarding the amortization of intangibles could be a significant action to occur in taxation which would have a substantial impact on business acquisitions.
• How informative are earnings numbers that exclude goodwill amortization? , Moehrle, S. R., Reynolds-Moehrle, J. A., & Wallace, J. S. (2001). How informative are earnings numbers that exclude goodwill amortization?. Accounting Horizons, 15(3), 243-255. The FASB or Financial Accounting Standards Board suggested in their original draft of Business Combinations and Intangible Assets that companies’ goodwill not get amortized when reporting share earnings. Only when the nominal dollar amount of the company’s apparent stock worth exceeds the company’s total capital, should it get written. Moehrle, Reynolds-Moehrle, and Wallace analyze the data of earning not including amortization of intangibles as it relates to the measurement of cash flow from business operations and of income before exceptional items. The study reveals that the explanation of earnings before amortization and the income following “extraordinary items” has no significant difference. Both assessment of earning after extraordinary items and earning before amortizing, prove more informative than analyzing the flow of cash from operations.
Measuring economic value added: A survey of the practices of EVA® proponents, Weaver, S. C. (2001). Measuring economic value added: A survey of the practices of EVA® proponents. Journal of Applied Finance, 11(1), 50-60. Weaver explains in this survey how the theory of EVAn, Economic Value Addedn, and its practice are miles apart while identifying how there is an inconsistency in EVAn measurement and its fundamental elements.
Amortization of intangibles: Is a mergers and acquisitions boom imminent?, Willens, R. W. (1993). Amortization of intangibles: Is a mergers and acquisitions boom imminent?. The CPA Journal, 63(11), 46. Willens discusses the Omnibus Budget Reconciliation Act of 1993 which permitted amortization of intangibles, such as licenses, goodwill, deposit base, and investment management, assembled workforce, mortgage-servicing agreements, customer lists, customer-based intangibles, subscriber lists, processes and formulae, copyrights, and patents. The prediction on Wall Street is that mergers and acquisitions will explode on the scene. Willens disagrees because there is no reinstatement of the “General Utility” principle, which allows assets to get “passed out of corporate solution” and there will not be a tax burden.
• Make or buy new technology: The role of CEO compensation contract in a firm’s route to innovation, Xue, Y. (2007). Make or buy new technology: The role of CEO compensation contract in a firm’s route to innovation. Review of Accounting Studies, 12(4), 659-690. Xue looks into how policies for management compensation are regulated with the strategic acquisition of new technology. The strategic choices of a company when using internal Research & Development (R&D) get labeled “make,” and with procurement, the strategies are called “buy.” The author says that a strategy to “make” has a considerable amount of risks. The U.S. generally accepted accounting practices (GAAP) expects acquisition costs to be turned into stocks and bonds and R&D expenditures get expensed. This GAAP means the accountable earnings of the company using the “make” strategy will be negatively impacted. Xue predicts more manager with risks to using the “buy” strategy and managers with stock-based earnings will probably choose the “make” strategy and develop the technology from within the firm.
• International accounting disharmony: the case of intangibles, Stolowy, H., & Jeny-Cazavan, A. (2001). International accounting disharmony: the case of intangibles. Accounting, Auditing & Accountability Journal, 14(4), 477-497. There is hope for accounting harmonization with compliance to the international standards of the International Accounting Standards (IAS). However, there seems to be a problem reaching this goal because there appears to be no accepted “conceptual framework” and no intra-country and inter-country consistency in defining and treatment of intangible assets. Stolowy and Jeny-Cazavan examine the challenges facing companies and the approach to total acceptance of all international accounting standards.
Intangibles, Lev, B. (2018). Intangibles. Lev claims the accounting standard-setters are not fully adapted to economic reality and how the growth of intangible investments have shifted business models and strategies from what used to be. The obliviousness of the standard-setters is causing adverse effects to investors and the entire economy. The authors say this resistance to changes in the accounting of intangibles has been ongoing for thirty years. Lev outlines an agenda that is based on new policies.
• Goodwill amortization and the usefulness of earnings, Jennings, R., LeClere, M., & Thompson, R. B. (2001). Goodwill amortization and the usefulness of earnings. Financial Analysts Journal, 57(5), 20-28. This study attempts to show from earning data, how goodwill amortization is an indicator of share value for companies, publicly traded during 1993-98. The Financial Accounting Standards Board approved new accounting guidelines, which gets rid of the systematic amortization of goodwill. Instead, the favorableness leans toward reviewing goodwill for damage when the situation calls for it. Jennings, LeClere, and Thompson discovered when earnings are the basis for share valuations, adding goodwill amortization brings along with it turbulence. Before goodwill amortization, distribution of share prices is observed. Their results show that by not including goodwill amortization in the computation of net income, there is no reduction of its usefulness to analysts and investors as a review of share value.
Accounting for intangibles: a literature review, Cañibano, L., Garcia-Ayuso, M., & Sanchez, P. (2000). Accounting for intangibles: a literature review. Journal of Accounting literature, 19, 102-130. Cañibano, Garcia-Ayuso, and Sanchez explain how financial accounting intends to provide useful information for current and prospective investors, creditors, and any entities who can use the details to make sound credit or investment decisions. The Authors believe those responsible for setting the accounting standard should set up a list of criteria which provide a fair valuation of intangible assets for proper financial reporting. The authors present a starting point for the set of principles by looking at the categorizing and defining of intangible elements, the relative significance of the assets for lending and investment determinations, and also methods to change the present model, so useful information regarding the factors define a company’s financial position in their accounting records.
Goodwill impairment potential: lessons from purchase acquisitions: knowing the source of expected synergies is important when assigning purchased goodwill to …, Eldridge, S. W. (2005). Goodwill impairment potential: lessons from purchase acquisitions: knowing the source of expected synergies is important when assigning purchased goodwill to reporting units. Bank Accounting & Finance, 18(6), 3-11. Eldridge discusses the substantial change to accounting for acquired goodwill and mergers. Of the changes made by the Financial Accounting Standards Board (FASB), impairment testing was made mandatory for goodwill and other intangible assets. Also, in 2001, when this change occurred, the FASB eliminated goodwill amortization. This article gives a rundown of the present-day rules of financial reporting for intangible assets earned in a business combination.
Goodwill accounting: Time for an overhaul, Davis, M. (1992). Goodwill accounting: Time for an overhaul. Journal of Accountancy, 173(6), 75. Davis believes that basing the definition of an intangible asset on the characteristic of it being “capable of being identified” is putting to the side the “most intangible of intangibles” to point out goodwill.
A pragmatic approach to amortization of intangibles, Dilley, S. C., & Young, J. C. (1994). A pragmatic approach to amortization of intangibles. The CPA Journal, 64(12), 46. Young discusses the new IRC or Internal Revenue Code Sec. 197 which was created to settle disputes between taxpayers and the IRS concerning the amortization of intangible assets. The author explains that goodwill under Sec. 197 can be amortized. Also, there is no need to have separate and distinct values set for goodwill to counter other intangible assets. There is a statutory recovery period of 15 years, which gives all intangibles the same useful life. Young expects the new section to bring positive assurance and costs reduction within the market. The author acknowledges the IRC Sec. 197 leaves any self-created intangibles uncovered.