Amortization

In accounting, amortization is a method of systematically allocating the cost of an intangible asset over its useful economic life. It recognises the expense associated with an intangible asset when its value declines because of use or the passage of time.

Amortization is calculated by considering the acquisition cost of the intangible asset and its residual value. The amortizable amount is then allocated systematically over the estimated useful economic life of the asset.

The basic concept of amortization is similar to depreciation. However, amortization is associated with intangible assets, while depreciation is the corresponding concept used for tangible assets.

Basic Concept of Amortization

An intangible asset may provide economic benefits to an entity for several accounting periods. Therefore, its cost is not necessarily treated as an expense entirely in the period in which the asset is acquired.

Instead, the cost of the intangible asset, after considering its residual value, is systematically allocated over the periods of its useful economic life. The amount allocated to each accounting period is recognised as an amortization expense.

Thus, amortization recognises the cost of using an intangible asset over the period during which the entity expects to obtain economic benefits from that asset.

Calculation of Amortization

The amortizable amount of an intangible asset is based on its acquisition cost less residual value.

The basic calculation is:

Amortizable Amount = Acquisition Cost − Residual Value

This amount is systematically allocated over the asset’s useful economic life.

Therefore, amortization may be expressed as:

Amortization Expense = Acquisition Cost Less Residual Value Allocated Systematically over the Useful Economic Life

The purpose is to allocate the cost of the intangible asset to the accounting periods in which the asset is used or provides economic benefits.

Useful Economic Life

The useful economic life of an intangible asset is the period over which the asset is expected to provide economic benefits to the entity.

Amortization is calculated over this useful economic life. As time passes or the intangible asset is used, a portion of its amortizable amount is recognised as an expense.

The systematic allocation continues during the useful economic life of the asset.

However, the treatment may be different for intangible assets that are considered to have an indefinite useful life.

Amortization and Depreciation

Amortization and depreciation are corresponding accounting concepts. Both are concerned with the systematic allocation of asset cost over the useful life of an asset.

The main difference is the type of asset to which the accounting treatment is applied.

Depreciation is the corresponding concept for tangible assets, while amortization is used for intangible assets.

Therefore, the cost of a tangible fixed asset may be allocated through depreciation, whereas the cost of an intangible asset may be allocated through amortization.

The methodologies used to allocate amortization to different accounting periods are generally similar to the methodologies used for depreciation.

Methods of Amortization

The methodologies for allocating amortization to each accounting period are generally the same as the methods used for depreciation.

The purpose of these methodologies is to systematically allocate the amortizable amount of an intangible asset over its useful economic life.

Therefore, the selected method determines how the acquisition cost less residual value is recognised as amortization expense in different accounting periods.

The basic requirement is that the cost should be allocated in a systematic manner over the useful economic life of the intangible asset.

Intangible Assets with Indefinite Useful Life

Certain intangible assets may be considered to have an indefinite useful life. Examples given include goodwill and certain brands.

An intangible asset with an indefinite useful life may not be subject to regular amortization because a definite period for systematic allocation of its cost cannot be determined.

Therefore, many intangible assets such as goodwill or certain brands may not be amortized when they are considered to have an indefinite useful life.

However, this does not mean that such assets are completely ignored for accounting purposes.

Goodwill and Impairment Test

Goodwill may be considered an intangible asset having an indefinite useful life and may therefore not be subject to regular amortization.

However, goodwill is subjected to an impairment test every year.

An impairment test examines whether the carrying value of the asset has suffered a decline that requires recognition in the financial statements.

Thus, the important distinction is that goodwill may not be regularly amortized, but it is tested annually for impairment.

Practical Use of Amortization

Theoretically, amortization is used to account for the decreasing value of an intangible asset over its useful life.

In practice, companies may also amortize costs that would otherwise be treated as one-time expenses. Such costs may be listed as capital expenses in the Cash Flow Statement and their cost may then be allocated through amortization over different accounting periods.

Instead of recognising the entire expense in one fiscal year or quarter, the cost is spread over several periods through amortization.

This treatment may have the effect of improving the company’s reported net income in the fiscal year or quarter in which the expenditure is incurred, because the entire amount is not recognised as an expense immediately.

Effect of Amortization on Balance Sheet

Amortization is recorded in the financial statements as a reduction in the carrying value of the intangible asset in the Balance Sheet.

As amortization is recognised over the useful economic life of the asset, the carrying amount of the intangible asset is reduced.

Therefore, the Balance Sheet reflects the remaining carrying value of the intangible asset after considering the amortization recognised.

Effect of Amortization on Income Statement

Amortization is also recognised as an expense in the Income Statement.

The amortization expense represents the portion of the intangible asset’s cost allocated to the current accounting period.

Since amortization is an expense, it affects the reported net income of the entity.

Thus, amortization has two important financial statement effects: it reduces the carrying value of the intangible asset in the Balance Sheet and is recognised as an expense in the Income Statement.

Accounting Treatment of Amortization

Amortization expense is recognised in the accounting records for the relevant accounting period.

The general accounting entry may be shown as:

Amortization Expense A/c Dr.
To Intangible Asset/Accumulated Amortization A/c

The Amortization Expense Account is charged to the Income Statement.

The credit entry reduces the carrying value of the intangible asset directly or records the accumulated amortization associated with the asset.

Thus, the accounting entry reflects both the expense recognised during the accounting period and the reduction in the carrying amount of the intangible asset.

International Financial Reporting Standards

Under International Financial Reporting Standards (IFRS), guidance relating to the accounting and amortization of intangible assets is contained in IAS 38.

IAS 38 provides accounting guidance for intangible assets and their amortization.

Therefore, for examination purposes, it is important to remember that IAS 38 deals with intangible assets and provides guidance on their amortization under IFRS.

Treatment under United States GAAP

Under United States Generally Accepted Accounting Principles, the primary guidance relating to the accounting treatment of amortization of intangible assets is contained in FAS 142.

Thus, the accounting treatment of intangible assets and amortization is governed by relevant accounting standards under different financial reporting frameworks.

Exam Focus

Amortization is the systematic allocation of the acquisition cost less residual value of an intangible asset over its useful economic life.

The basic calculation is:

Amortizable Amount = Acquisition Cost − Residual Value

The main distinction is that amortization applies to intangible assets, whereas depreciation is the corresponding concept for tangible assets.

The methodologies used for allocating amortization to accounting periods are generally similar to depreciation methodologies.

Intangible assets having an indefinite useful life may not be subject to regular amortization. Goodwill may not be regularly amortized but is subjected to an impairment test every year.

Amortization is recognised as a reduction in the carrying value of the intangible asset in the Balance Sheet and as an expense in the Income Statement.

Under IFRS, guidance on the amortization of intangible assets is contained in IAS 38, while under United States GAAP, the primary guidance is contained in FAS 142.