What Is the Amortization of Intangibles?

Amortization of intangibles is the process of expensing the cost of an intangible asset over the projected life of the asset. The amortization process for corporate accounting purposes may differ from the amount of amortization posted for tax purposes. Intangible assets, such as patents and trademarks, are amortized into an expense account. Tangible assets are posted to expenses through depreciation.

Key Takeaways

  • Amortization is a process by which the cost of an asset is expensed over a specific time frame.
  • Amortization applies to intangible (non-physical) assets, while depreciation applies to tangible (physical) assets.
  • Intangibles include patents, goodwill, trademarks, and human capital.

Understanding Amortization of Intangibles

For tax purposes, the cost basis of an intangible asset is amortized over a specific number of years, regardless of the actual useful life of the asset. In the years the asset is acquired and sold, the amount of amortization deductible for tax purposes is prorated on a monthly basis. Intangible amortization is reported on IRS Form 4562.

Intangible assets are nonphysical assets that can be assigned an economic value. According to Section 197 of the Internal Revenue Code, there are numerous qualifying intangible assets, but the most common are patents, goodwill, the value of a worker's knowledge, trademarks, trade and franchise names, noncompetitive agreements related to business acquisitions, and a company's human capital.

Example of an Intangible Asset

Intellectual property (IP) is considered to be an intangible asset. Intellectual property includes patents, copyrights, and goodwill. When a parent company purchases a subsidiary company and pays more than the fair market value of the subsidiary's net assets, the amount over fair market value is posted to goodwill, an intangible asset. IP is posted as an asset on the firm's balance sheet when it is purchased. IP cannot be internally generated by a company's own research and development (R&D) efforts.

Amortization vs. Depreciation

Assets are used by businesses to generate revenue and produce net income. Over a period of time, the costs related to the assets are moved into an expense account. By recognizing an expense for the cost of the asset, the company is complying with Generally Accepted Accounting Principles (GAAP) which require the matching of revenue with the expense incurred to generate the revenue. Tangible assets are expensed using depreciation, and intangible assets are expensed through amortization.

Recording Depreciation and Amortization

Assume, for example, that a carpenter uses a $32,000 truck to perform residential carpentry work, and that the truck has a useful life of eight years. The annual depreciation expense on a straight-line basis is the $32,000 cost basis divided by eight years, or $4,000 per year.

On the other hand, assume that a corporation pays $300,000 for a patent that allows the firm exclusive rights over the intellectual property for 30 years. The firm's accounting department posts $10,000 of amortization expense each year for 30 years.

Both the truck and the patent are used to generate revenue and profit over a particular number of years.