Amortization is gradual reduction in cost of an intangible finite (limited life) asset. When a company performs the amortization computation for a period, it prorates the initial cost of the assets over its useful life. The firms do these calculations almost the same way as they would if the depreciation should be calculated. When calculating amortization an entity should deduct capital expenses over service life of an asset. The difference between depreciation and amortization is that depreciation refers to tangible assets while amortization to intangible ones.
What are intangible assets?
Intangible assets are those that do not have physical form (substance) as it is with tangible assets where you can actually see and tough them. There is an exception with such account as Accounts Receivable where it is lacks physical substance as well, but since it is considered a financial instrument this account is not one of intangible assets. Intangible assets are not financial instruments because there is no a right to claim cash for it as with accounts receivable. Despite the characteristics mentioned above intangible assets commonly are among the most valuable assets (economic resources) that a company usually has.
Intangible assets can have finite and indefinite life which means that the assets might have certain limited period of its service life or not. For instance the brand name usually won’t have definite life because it exists by the time the company ceases its existence. In contrast, a patent has its certain service life and must be amortized over it accordingly. If the expected useful life of a finite (limited) intangible asset changes while it still didn’t reach its economic life than the remaining carrying (book) value should be amortized over the revised remaining service life. Examples of intangible assets are patents, copyrights, trademarks, trade names, franchises, licenses, and goodwill.
What is accounting methods to calculate amortization?
Straight line amortization method is typically used for the intangible assets.
An entity may determine the amount of an intangible asset to be amortized by using the following formula,
(Initial cost* – Residual value**) / # of years of services life.
*The initial cost will include the purchase price of the asset plus any additional cost directly associated with that.
**Residual value is the amount the asset will be worth at the end of its service life if it will be sold to some other company. Residual value of an intangible asset typically estimated when the service life of the asset is less than its economic life. For example, if economic life is 17 years for a parent and it is service life is 5 years then it might be a chance that someone will be interested to purchase it at the end of its useful life. Commonly, however, intangible finite assets are obsolete at the end of their useful life and have $0 value accordingly. It is especially the case with rapidly changing technology.
For example, let’s assume that a patent has 17 years of its service life and was purchased for $85,000 without incurring any additional cost for its intended use. To compute the patent amortization the company needs to divide the purchased price of such asset by numbers of years it will be in use. So, they would divide $85,000 by 17 years and get $5,000 of the annual amortization expense.
What is accounting entries to record an intangible asset’s amortization
Dr. Intangible asset amortization expense
Cr. Intangible asset (name)
(to record an annual amortization expense of an intangible asset)