Amortization is the systematic allocation of the cost of an intangible asset to income statement over its useful life.
Why an intangible asset is recorded in the balance sheet instead of charging the cost of intangible as expense in the period in which that intangible is acquired? The reason for this is the entity’s expectation of related economic benefits. As the related economic benefits are expected to be obtained in the next few years (over the useful life of intangible asset), therefore, to match the expenses with benefits, intangible is initially recorded as an asset, and is amortized over its useful life or in other words, its cost is systematically allocated to income statement as expense over its useful life.
If the pattern of inflow of economic benefits is known, then amortization of intangible assets can be calculated to match the pattern of inflows. For example, if an intangible having useful life of three years is expected to generate $50,000 in first year, $30,000 in second year, and $20,000 in third year, then accordingly, amortization can be charged in the following manner:
- Year 1 – 50% of total cost of intangible asset
- Year 2 – 30% of total cost of intangible asset
- Year 3 – 20% of total cost of intangible asset
However, in most of the cases, pattern of inflows cannot be predicted with reasonable certainty. Therefore, the most commonly used method to calculate amortization of intangible assets is the straight-line method, which assumes that economic benefits associated with the intangible assets are generated uniformly over their useful lives. Formula for calculating amortization on straight-line basis is as follows:
You must have noticed that amortization of an intangible asset is linked with its useful life. But what about intangible with indefinite useful life? Let’s see how the accounting of such intangibles is done.
Intangibles with indefinite useful life
There are intangible assets whose life cannot be determined, for instance, useful life of acquired goodwill is not possible to determine. Similarly, any other intangible asset can have an indefinite useful life.
Intangible assets with indefinite useful lives are not amortized, however, such intangible assets should be tested for impairment at each reporting date in addition to the impairment testing being done whenever any impairment indications have been observed. Our chapter “Impairment of intangible assets” further elaborates the concepts related to impairment of intangibles.
We have discussed the amortization of intangible assets, now let’s go through the following illustration to further clarify our knowledge of this topic.
On 1 January 20×0, Company A purchased following two intangibles:
- a special trading license for $100,000 which is valid for five years
- A brand whose useful life cannot be ascertained (indefinite useful life)
What will be the amortization expense for both intangible assets for the year ended 31 December 20×0?
1. Trading license has a useful life of 5 years, so its amortization will be calculated using the following formula.
2. As the brand has an indefinite useful life, so no amortization will be charged for brand. It will be tested for impairment.