What is Amortization?
Amortization is the process of distributing the cost of an intangible asset over a certain period, which is usually the duration of the useful life of that intangible asset. Patents, trademarks, and copyrights are examples of valuable intangible assets that a company may acquire by incurring an expense.
How to Calculate the Amortization of an Asset
If a company acquires the exclusive rights for ten years to manufacture a new product from the patent holder by paying $10 million to the inventor, this expense should be amortized over the ten years. The straight-line method of amortization leads to the company having an amortization expense of $1 million per year to be recorded in the company’s income statement.
The same calculation method is used to amortize expense if a pharmaceutical company acquires the exclusive rights to manufacture a patented drug newly approved by the Food and Drug Administration.
Notable Features of Amortization and Depreciation
- Amortization applies to intangible assets, whereas depreciation applies to tangible or physical assets
- Amortization is calculated for intangible assets in the same way as depreciation calculated for tangible assets.
- However, unlike tangible assets, intangible assets have no salvage value at the end of their life.
- The intangible assets may be patents and trademarks, goodwill, or copyright. Other intangible assets that amortized include franchise agreements, proprietary or copyrighted manufacturing processes, and patented designs.
- The tax department may allow taxpayers to deduce certain expenses, including expenditures on intangibles like goodwill, patents, copyrights, and trademarks.
- Goodwill is recorded in the books when one company acquires another at a price higher than the fair market value of that company. However, goodwill itself cannot be bought or sold. It is challenging to value goodwill. Hence, a company may overvalue the goodwill component of a company it is acquiring. The net assets of such an acquired company may fall in value forcing the acquiring company to write down those assets in a process called impairment. Impairment charges are a part of the income statement and negatively affect a company’s earnings per share (EPS) and stock price.
- Intangible assets can constitute a significant fraction of a company’s total assets and, therefore, hugely impact the company’s book value. While calculating the book value of a company, most analysts will only include the intangible assets that can be sold independent of the company – patents and copyrights are examples of such intangible assets, but goodwill is not.
In the new tech economy, the value and importance of intangible assets continue to rise. Consider the immense amount of an ‘intangible’ asset like ‘Google’ or ‘iPhone.’ But intangible assets can disappear as quickly as they appear. Think ‘AOL’ or ‘Yahoo.’ Some intangible assets pre-date the ‘FAANG’ companies though – think ‘Coca Cola’ or ‘Gilette.’