Updated July 14, 2023
Definition of Amortization of Intangible Assets
Amortization of intangible assets is a process under which the cost of an intangible asset is reduced over a specified period, also called expected useful life. The general meaning of intangible is ‘without physical substance’.
Intangibles are assets that may not have a physical substance but are still valuable resources for an entity.
Explanation
Like depreciation for tangible assets, amortization transfers part of the value of the intangible asset from the balance sheet to the income statement as a cost. Depreciation is done for tangible assets, and amortization is done for intangible assets.
Examples of Intangible assets are goodwill, patents, copyrights, and trademarks.
How to Calculate Amortization of Intangible Assets
Accounting of an intangible asset depends upon its useful life, i.e., finite or indefinite. An intangible asset with a finite useful life is amortized, while those with indefinite useful life are not.
Amortization of an intangible asset begins when the asset is ready to use. Like depreciation, multiple methods are available to calculate an asset’s amortization, but the simplest is the straight-line method.
The method for amortization selection should reflect how the asset’s future economic benefits are expected to be consumed. If the company cannot determine that pattern reliably, the straight-line method should be used.
Steps to Calculate Amortization
- For calculating amortization under the straight-line method, we need three figures; the cost of an asset, residual value, if any, and its useful life.
- The cost of an asset is usually the price paid to acquire the asset. If an asset is created in-house, the total cost is incurred until it is ready.
- Residual value is its scrap value which is normally zero in the case of intangible assets.
- The useful life of an intangible asset is the period over which an asset expects to be available for use by an entity.
- The formula to calculate amortization is (Cost of an asset – Residual value) / Useful life of the asset.
- After a few years of using the asset, if the company finds out that the intangible asset is no longer useful for the company, it can immediately write off the asset from its books of accounts. The remaining cost of the asset will be booked as an expense in the Income statement, and the asset’s value will be zero.
Amortization of Intangible Assets Journal Entry
Amortization Calculated as Per the Straight Line Method Is Booked as An Expense Under the Income Statement. In The Balance Sheet, the Balance of The Accumulated Amortization Account Will Be Increased, Thereby Reducing the Net Cost of The Asset.
Below are the Journal entries booked for the amortization of the asset:
| Date | Account Title & Explanation | Debit ($) | Credit ($) |
| 31-Dec | Amortization Expense A/c | XXX | |
| To Accumulated Depreciation – Patents | XXX | ||
| (To book amortization of Intangible assets) |
| Date | Account title & explanation | Debit ($) | Credit ($) |
| 31-Dec | Accumulated Depreciation – Patents | XXX | |
| To Patents A/c | XXX | ||
| (To book amortization of Intangible assets) |
Example of Amortization of Intangible Asset
Bharthi Ltd obtains a license with a finite useful life of 10 Years for $100 million. These rights are available for the next 10 years. After 10 years, the licenses would need to go under the hammer, and the company would need to bid again for these licenses.
In the above case, the telecom operating license is an intangible asset with a finite useful life of 10 years. Bharthi Ltd should recognize it as an intangible asset in its books and amortize it over a period of 10 years.
Using the straight-line method for amortization,
- Cost of the asset = $100 million
- Residual value = 0
- Useful life = 10 Years
Solution:
Amortization calculates as
- Amortization = (100 – 0) / 10
- Amortization = $10 million
| Date | Account Title & Explanation | Debit ($) million | Credit ($) million |
| XXX | Amortization Expense A/c | 10 | |
| To Accumulated Depreciation Licence | 10 | ||
| (To book amortization of Intangible asset |
| Date | Account Title & Explanation | Debit ($) million | Credit ($) million |
| XXX | Accumulated Depreciation – Patents | 10 | |
| To Licence A/c | 10 | ||
| (To book amortization of Intangible asset |
Advantages
Below are a few advantages of amortizing intangible assets:
- Amortization cost records as an expense in the entity’s books of account, hence lower profits, leading to lesser taxes for the firm.
- Assessing the benefits of an intangible asset and determining the duration of those benefits facilitates amortization.
- Amortization helps to find the actual value of the asset for the business.
Limitations
Below are a few disadvantages of amortization of intangible assets:
- It is difficult to calculate the useful life of an intangible asset. If useful life is not correct, the amortizing cost would be incorrect.
- Also, it is difficult to calculate the actual cost of intangible assets as they are not physical in nature.
Conclusion
Intangible assets are an important part of a company’s financial statement; hence it is very important to correctly measure and recognize them so that true and fair value is shown in the books. Amortization helps to calculate the actual value of the asset for the business.
Recommended Articles
This is a guide to the Amortization of Intangible Assets. Here we also discuss the definition and how to calculate the amortization of intangible assets along with advantages and disadvantages. You may also have a look at the following articles to learn more –
