Amortization and impairment both relate to the value of a company's intangible assets, which are reported on the balance sheet. Intangible assets include goodwill, or value within the company's name and reputation itself. Also, patents, trademarks, and copyrights are given a value and reported as intangible assets. As with any other asset, there is an estimated lifespan and, thus, depreciation over time. Amortization is used to reflect the reduction in value of an intangible asset over its lifespan. Impairment occurs when an intangible asset is deemed less valuable than is stated on the balance sheet after amortization.
The idea behind amortization is that it illustrates the expense of using up an intangible asset's value to produce revenue. To determine amortization, the company determines a present value for the intangible asset and defines its useful life expectancy, just as with calculating depreciation. The annual amount is deducted each year on the balance sheet to reflect the current value for the asset. This is done through a debit entry to the amortization expense account and credit to the contra account that is reported on the balance sheet called accumulated amortization. The amount is also reported on the income statement for each accounting period as an expense against operating profit, along with taxes, interest, and depreciation. The result is net income, which is used to determine earnings per share. For this reason, overstating or understating the asset's salvage value and useful life can make quite an impact on the company's bottom line.
As amortization directly affects a company's reported net income, it is an extremely important component for investors to evaluate. New rules for generally accepted accounting principles, or GAAP, require intangible asset values to be re-evaluated at least annually. If the fair value is determined to be less than the current valuation of the intangible asset, minus the amortization expense, the asset is said to be impaired. If this is the case, the difference in fair value and current value is recorded as an impairment charge. This entry adjusts the intangible asset to the fair market value on the balance sheet.
Many times when a company acquires another company's assets, the usurped company's goodwill deflates in value. In such a case, the impairment cost is charged off the new owning company's books to bring the asset's value to fair market valuation. As long as a company handles impairment costs responsibly, investors can see accurate valuations of the company. With so many variables and inferences involved with determining amortization and the life expectancy of an intangible asset, however, impairment cost can be used to manipulate the balance sheet. One of the main factors contributing to manipulation is the fact that declared values of intangible assets are not required to be reported.