A business uses amortization to spread the cost of an intangible asset over its useful life, or the life of the intangible asset in the business. An intangible asset is one without a physical presence, such as a patent. This amortization process reduces a company’s assets and stockholders’ equity on its balance sheet.
About Amortization
A business records the cost of an intangible asset in the assets section of its balance sheet only when it purchases it from another party and the asset has a finite life. The company transfers a portion of the asset's cost from the balance sheet to an expense on the income statement each accounting period. It does this instead of recording the entire cost as an expense on its income statement at the time of purchase.
Calculating Amortization
An intangible asset’s annual amortization expense equals its original cost minus its salvage value, divided by its useful life. Salvage value is the value you expect an intangible asset will be worth at the end of its useful life. For example, assume an intangible asset has an expected useful life of five years, an original cost of $1,100 and a salvage value of $100. Subtract $100 from $1,100 to get $1,000. Divide $1,000 by 5 to get an annual amortization expense of $200.
Effect on Assets
An intangible asset’s annual amortization expense reduces its value on the balance sheet, which reduces the amount of total assets in the assets section of the balance sheet. This occurs until the end of the intangible asset’s useful life. For example, if an intangible asset has a five-year useful life and a $200 annual amortization expense, its value on the balance sheet would be reduced by $200 annually for five years, which would reduce total assets by $200 annually.
Effect on Stockholders’ Equity
Annual amortization expense reduces net income on the income statement, which also reduces retained earnings in the stockholders’ equity section of the balance sheet. Net income equals revenue minus expenses. Retained earnings consists of a company’s net income that it has kept in its business. For example, a $200 annual amortization expense would reduce net income by $200 on the income statement. In turn, this would reduce retained earnings on the balance sheet by $200.
Businesses use depreciation on physical assets such as buildings and equipment to spread the cost of the assets over time, allowing the expense to be deducted while the assets are in use. For intangible assets, however, a different system is needed, because there is no physical property that can depreciate. This is where amortization, a process by which companies may record the costs of an intangible asset in increments to allow for continued deductions, comes in. Amortization expenses accounts are where businesses record the periodic amounts being expensed.
Understanding Amortization Basics
According to Investopedia, in much the same way that they depreciate physical property, companies use amortization to spread out the cost of an intangible asset that has a fixed useful life over the asset’s life. This method of recovering company capital is quite similar to the straight-line method of depreciation seen with physical assets. The alternative would be to absorb the full cost of the asset in a single accounting period, which would make profits for the period seem smaller and would violate the concept of matching expenses and revenue.
Intangible Assets 101
Accounting Tools reports that intangible assets are defined as those with a lack of physical existence but have a long-term benefit to the company. Amortization is most often applied to purchases of trademarks, patents, copyrights, licensing and contracts, properties that provide tangible benefit to the company but only for a certain length of time. Business start-up costs may be amortized, too, but generally, they, as well as other intangible assets, can only be amortized for a maximum of 15 years. Some intangible assets provide benefit to a company for an indefinite period, but these may not be amortized. Amortization is strictly limited to assets that are only useful for a determined span of time.
Accounting Steps and Amortization
In company record-keeping, before amortization can occur, the purchase of the asset must be recorded. The cost of the asset is entered in a balance sheet account, with the offsetting entry to the account representing the method of payment, such as cash or notes payable. The company determines the useful life of the asset and divides the purchase amount by the number of accounting periods occurring during that life. For example, a company purchases a patent for $120,000 and determines its useful life to be 10 years. The annual amortization expense will be $12,000, or $1,000 a month if you are recording amortization expenses monthly. Amortization expense is an income statement account affecting profit and loss. The offsetting entry is a balance sheet account, accumulated amortization, which is a contra account that nets against the amortized asset.
Amortization and Taxes
The Internal Revenue Service requires companies to report their amortization expenses on a separate schedule when they file their income tax returns. The proper form to use is IRS Form 4562. Complete Part VI and submit it with your tax return. It is not necessary to file a Form 4562 if there are no new amortizable expenses for the year and there is no depreciation to report. Amortization begun in a previous year is simply reported on the return itself under either “Other Expense Line” or “Other Deduction.”