Amortization of Intangible Assets: Methods and How To Calculate

Amortization of acquired intangible assets is an essential accounting practice that enables businesses to systematically allocate the cost of intangible assets over their useful lives. Similar to depreciation for tangible assets like machinery or buildings, amortization helps companies reflect the gradual consumption of valuable intellectual properties on their financial statements, such as patents, software, and trademarks. By spreading the expense over several years, amortization ensures more accurate financial reporting, aligns costs with revenues, and allows businesses to manage taxes and compliance effectively.

What is Amortization of Intangible Assets?

Amortization of intangible assets is the process of gradually expensing the cost of an intangible asset over its useful life. Amortization of intangible assets is comparable to depreciation of tangible assets such as vehicles or machinery; amortization is used for intangibles such as software, patents, or trademarks.

Amortization is the process of allocating the cost of an intangible asset over a specific period, which generally reflects the asset's useful life. This happens through recurring costs on the income statement. The amount of amortization is usually determined by dividing the asset's total cost by its estimated useful life.

Amortization of Intangible Assets Example

A company acquires software for $10,000. The useful life of the software is estimated to be 5 years. The company decides to amortize the software using the straight-line method, which means the same amount will be amortized each year.

Firstly, we need to calculate the annual amortization and divide the cost of the software by its useful life.

Software Cost = $10,000

Useful Life = 5 years

Annual Amortization Expense = 10,000 ÷ 5 = 2,000

So, the company will amortize $2,000 every year for 5 years.

Each year, the company will make the following journal entry for amortization of intangible assets (software):

Importance of Amortization of Intangible Assets for Business

Amortization of intangible assets is critical to businesses for multiple reasons, which may be emphasized from several perspectives highlighted below:

Accurate Financial Reporting

Amortization helps in accurately reflecting the cost of intangible assets over their useful life. By expensing a portion of the asset’s cost each year, businesses can present a more realistic picture of their financial position.

Matching Revenues and Expenses

Amortization follows the matching principle in accounting, which states that expenses should be recorded in the same period as the revenues they help generate. Since intangible assets contribute to business operations over many years, amortization ensures that their costs are spread out over time.

Tax Benefits

Amortization is a non-cash expense, meaning it reduces the company’s taxable income without affecting cash flow. By spreading out the amortization expense, businesses can benefit from tax deductions annually instead of all at once.

Budgeting and Financial Planning

Knowing how much an intangible asset will be amortized each year helps businesses with budgeting and financial forecasting. It allows businesses to plan, manage cash flow, and make informed investments.

Compliance with Accounting Standards

Many countries that follow GAAP and IFRS require amortization of intangible assets to ensure compliance. Noncompliance with these regulations may result in penalties or legal challenges. Therefore, proper amortization practices are essential for maintaining good standing.

Assessing Asset Impairment

Amortization helps to track the value of intangible assets over time, and businesses must test for impairment if the asset's value declines significantly. Businesses that constantly record amortization can better identify when an asset's value has been impaired and take necessary action, such as reducing the asset's carrying amount.

Methods of Amortization for Intangible Assets

There are several ways of amortization for intangible assets, the most common of which is the straight-line method. However, depending on the nature of the intangible asset and the company's accounting policies, different methods may also be used.

1- Straight-Line Method

This is the method of amortization used for intangible assets across a wide range of industries. Under the straight-line method, the cost of the intangible asset is amortized evenly over its useful life.

Formula

Annual Amortization Expense = Initial Cost of the Asset − Salvage Value ÷ Useful Life of the Asset

For example, if a company acquires a patent for $50,000 with a useful life of 10 years and no salvage value, the annual amortization expense would be:

Annual Amortization = (50,000 - 0) ÷ 10 = 5,000

2- Declining Balance Method

In this method, amortization is calculated based on the book value of the asset at the beginning of each period, rather than its original cost. The asset is amortized more in the earlier years of its useful life, with the expense decreasing as the asset's book value decreases.

Formula

Annual Amortization Expense = Book Value at Beginning of Year × Amortization Rate

For example, if the amortization rate is 20% and the initial cost of the asset is $50,000, then the first year’s amortization will be:

50,000 × 20% =10,000

In the second year, the amortization expense will be calculated based on the new book value ($50,000 - $10,000 = $40,000):

40,000 × 20% =8,000

This continues each year with the amortization expense declining.

3- Sum-of-the-Years'-Digits Method

The Sum-of-the-Years'-Digits method is an accelerated amortization method, meaning the asset is amortized faster in the earlier years. This method assigns a greater percentage of the total amortization expense to earlier periods and less to later periods.

Formula

Annual Amortization Expense = Remaining Useful Life ÷ Sum of the Years’ Digits × (Cost of the Asset − Salvage Value)

For example, the sum of the digits for the asset’s useful life. For an asset with a useful life of 5 years, the sum of years digits would be: 5 + 4 + 3 + 2 + 1 = 15

The first year’s amortization would be:

Amortization for Year = 5 ÷ 15 × (50,000−0) = 16,667

The second year’s amortization would be:

Amortization for Year 2 = 4 ÷ 15 × 50,000 = 13,333

This pattern continues, with amortization decreasing over the asset’s useful life.

4- Units of Production Method

This method amortizes the intangible asset based on its usage, rather than the passage of time. It is typically used for intangible assets where the consumption of the asset is tied to output or usage, such as software licenses or patents that are tied to units produced or sold.

Formula

Amortization Expense = (Cost of the Asset − Salvage Value ÷ Total Estimated Units of Output) × Units 

For example, if a company acquires a patent for $50,000 with an expected usage of 100,000 units, and in a given year it produces 20,000 units, the amortization for that year would be:

Amortization for Year = (50,000 – 0 ÷ 100,000) × 20,000 = 10,000

In this method, the amortization expense is directly linked to the asset’s actual usage or output.

How to Calculate Amortization of Intangible Assets

Calculating amortization of intangible assets involves several steps which are:

1- Determine the Cost of the Intangible Asset

The first step is to determine the initial cost of the intangible asset. This could include the purchase price, legal fees, and other costs directly associated with acquiring the intangible asset.

2- Estimate the Salvage Value

Next, estimate the salvage value (residual value) of the intangible asset at the end of its useful life. For intangible assets, this value is often considered zero because most intangible assets do not have a resale value after their useful life expires.

3- Determine the Useful Life of the Asset

Estimate how long the intangible asset will provide value to the company. This is known as its useful life.

4- Apply the Amortization Formula

Use the following formula for Straight-Line Amortization:

Annual Amortization Expense = Initial Cost of the Asset − Salvage Value ÷ Useful Life of the Asset

5- Record Amortization Journal Entries

Each year, the company will record the amortization expense in its financial statements. The journal entry is:

• Debit Amortization Expense (Income Statement)
• Credit Accumulated Amortization (Balance Sheet)

This journal entry reflects the periodic expense that reduces the book value of the intangible asset.

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FAQs About Intangible Assets

How long do you amortize intangible assets?

If an intangible asset has a finite useful life, it is amortized over that period. The useful life is usually determined based on factors like legal or contractual limitations, technological advancements, or the asset's expected usage.

Some intangible assets, such as goodwill, trademarks, and certain types of brand names, may have an indefinite useful life, meaning they are not amortized. Instead, these assets are tested for impairment annually or whenever there is an indication of a decline in value. If the asset's fair value falls below its book value, an impairment loss is recognized, and the asset's value is adjusted accordingly.

In some cases, the useful life of an intangible asset might change over time due to new information or circumstances. If an asset's useful life is extended or shortened, the amortization schedule may be adjusted prospectively 

What is an example of amortization of intangible assets?

A company that acquires a patent for $50,000, and the patent has a useful life of 5 years with no salvage value. The company will amortize the patent using the straight-line method.

Determine the Acquisition Cost of the Intangible Asset: The initial cost of the patent is $50,000.

Estimate the Useful Life: The useful life of the patent is estimated to be 5 years.

Estimate the Salvage Value: Since intangible assets like patents typically have no residual value, we assume the salvage value is $0.

Apply the amortization of intangible assets formula: Using the straight-line method, the annual amortization expense is calculated as:

Amortization Expense = Acquisition Cost − Salvage Value ÷ Useful Life of the Asset

Substituting the values: 

Amortization Expense = 50,000 – 0  ÷5 = 10,000

Therefore, the annual amortization expense will be $10,000 per year.

 

How do you record amortization of intangible assets?

To record the amortization of intangible assets in accounting, you make journal entries that reflect the periodic amortization expense and the reduction of the asset’s book value on the balance sheet.

Amortization Entry Summary:

What are differences between depreciation and amortization of intangible assets?

Read Also: Depreciation Methods and Calculations: Comprehensive Guide