Understanding Intangible Assets and Amortization Expense

A goodwill account appears in the accounting records only if goodwill has been purchased. A company cannot purchase goodwill by itself; it must buy an entire business or a part of a business to obtain the accompanying intangible asset, goodwill. Since these positive factors are not individually quantifiable, when grouped together they constitute goodwill.

Unit 11: Plant Assets and Intangible Assets

• Both are reported on the balance sheet but have different accounting treatments; tangible assets are depreciated while intangible assets are typically amortized.
• The parties involved in a franchise arrangement are not always private businesses.
• Goodwill is an exception; it is not amortized but tested for impairment.

Amortization is the systematic allocation of the asset’s cost over its expected useful life. If the value of an intangible asset declines permanently, it must be impaired, meaning its carrying value is reduced on the balance sheet to reflect its fair value. Intangible assets have either an identifiable or indefinite useful life. However, something like goodwill that is purchased when a company buys another company has an undefined useful life. At Vedantu, we make complex topics like intangible assets simple through easy tables, clear examples, and up-to-date accounting standards.

Amortization and Impairment of Intangible Assets

Tangible assets are physical and touchable (e.g., buildings, machinery), while intangible assets lack physical form but hold economic value (e.g., patents, brand reputation). Both are reported on the balance sheet but have different accounting treatments; tangible assets are depreciated while intangible assets are typically amortized. Intangible assets with identifiable value and finite useful lives are reported on the balance sheet as non-current assets. They are initially recorded at cost and then amortized over their useful life. Goodwill, however, is not amortized but tested for impairment annually. In accounting, goodwill is an intangible value attached to a company resulting mainly from the company’s management skill or know-how and a favorable reputation with customers.

The finite useful life for a copyright extends to the life of the creator plus 50 years. Straight-line amortization is calculated the same was as straight-line depreciation for plant assets. Generally, we record amortization by debiting Amortization Expense and crediting the intangible asset account. An accumulated amortization account could be used to record amortization. However, the information gained from such accounting would not be significant because normally intangibles do not account for as many total asset dollars as do plant assets. When purchasing a patent, a company records it in the Patents account at cost.

Understanding Intangible Assets and Amortization Expense

After investments and other assets (covered in the next section), the company lists goodwill and then other intangibles, net of amortization. In addition to providing benefits, a franchise usually places certain restrictions on the franchisee.

Financial Accounting

Building up a good reputation with customers or establishing a well-known brand is not recorded as an intangible asset. Intangible assets are reported on the balance sheet, typically under non-current assets. This section lists long-term assets providing future economic benefits. The specific presentation depends on accounting standards (e.g., IAS 38, AS 26). Amortization systematically allocates the cost of an intangible asset over its useful life.

A company’s value may be greater than the total of the fair market value of its tangible and identifiable intangible assets. This greater value means that the company generates an above-average income on each dollar invested in the business. Thus, proof of a company’s goodwill is its ability to generate superior earnings or income. Intangible means without physical existence, in contrast to buildings, vehicles, and computers. Amortization refers to the allocation of the cost of an intangible asset over its estimated economic life. Intangible assets are non-physical resources that hold measurable value for businesses and organizations.

• A company’s value may be greater than the total of the fair market value of its tangible and identifiable intangible assets.
• Intangible assets with identifiable value and finite useful lives are reported on the balance sheet as non-current assets.
• Since these positive factors are not individually quantifiable, when grouped together they constitute goodwill.

Amortization will however begin when it is determined that the useful life is no longer indefinite. The method of amortization would follow the same rules as intangible assets with finite useful lives. Impairment of intangible assets reduces their carrying value on the balance sheet, signaling a decrease in future economic benefits. This can negatively impact company valuation as it suggests lower profitability and reduced future cash flows, affecting investor confidence and potentially loan agreements. Unlike tangible assets that are depreciated, intangible assets (except goodwill) are amortized.

Intangible assets are generally both nonphysical and noncurrent; they appear in a separate long-term section of the balance sheet entitled “Intangible assets”. For example, an individual who wishes to open a hamburger restaurant may purchase a McDonald’s franchise; the two parties involved are the individual business owner and McDonald’s Corporation. This franchise would allow the business owner to use the McDonald’s name and golden arch, and would provide the owner with advertising and many other benefits. A copyright is an exclusive right granted by the federal government giving protection against the illegal reproduction by others of the creator’s written works, designs, and literary productions.

The accounting for a lease depends on whether it is a capital lease or an operating lease. The proper accounting for capital leases for both lessees and lessors has been an extremely difficult problem. We leave further discussion of capital leases for an intermediate accounting text. The parties involved in a franchise arrangement are not always private businesses. A government agency may grant a franchise to a private company. A city may give a franchise to a utility company, giving the utility company the exclusive right to provide service to a particular area.

The finite useful life of such an asset is considered to be the length of time it is expected to contribute to the cash flows of the reporting entity. (Pertinent factors that should be considered in estimating useful life include legal, regulatory, or contractual provisions that may limit the useful life). The method of amortization should be based upon the pattern in which the economic benefits are used up or consumed. If no pattern is apparent, the straight-line method of amortization should be used by the reporting entity. Tangible assets are physical assets like property, plant, and equipment.

What you will learn to do: Account for intangibles

Correct presentation of intangible assets demonstrates an organization’s true financial strength. The accounting treatment for intangible assets involves recognizing them at cost, then amortizing them over their useful life (except for goodwill, which is tested for impairment). This is guided by accounting standards like IAS 38 and AS 26 and requires careful consideration of their nature and useful economic lives. Understanding intangible assets is required for analyzing company accounts, preparing for commerce exams, and making informed business choices. Concepts like goodwill, amortization, and impairment are frequently asked in financial statements and accounting standards exam questions. Initially, firms record intangible assets at cost like most other assets.

Importance of Intangible Assets in Business

Intangible assets are non-physical assets such as patents, copyrights, and brand recognition that provide future economic benefits. Understanding the difference is crucial for accounting and business valuation. Intangible assets appear under non-current assets on a company’s balance sheet. Their valuation follows accounting standards such as AS 26 and IAS 38. Most identifiable intangibles are amortized over their useful life, while goodwill is tested annually for impairment.

Goodwill is an exception; it is not amortized but tested for impairment. All intangible assets are nonphysical, but not all nonphysical assets are intangibles. For example, accounts receivable and prepaid expenses are nonphysical, the expensing of intangible assets is called yet classified as current assets rather than intangible assets.