Accounting for Long-term Assets
8.5 Intangible assets and amortization
Intangible assets provide their owners with intellectual property rights, privileges, etc. When acquiring such assets, their cost is capitalized in asset accounts at historical cost. Depending on the asset classification, the cost may be expensed over the asset useful life. The expense recognition process for intangible assets is called amortization.
Intangible assets fall into two major categories:
- Specifically identifiable assets with definite useful lives, and
- Goodwill and specifically identifiable assets with indefinite useful lives.
Specifically identifiable intangible assets are trademarks, patents, copyrights, etc. They are normally amortized on a straight-line basis. In order to determine the number of years over which to allocate the intangible asset cost, a company should choose the shortest of the following periods:
- Legal life of the intangible asset
- Useful life of the intangible asset, or
- Maximum amortization period fixed by the law of a particular country.
Suppose a company has acquired a trademark for $5,000 that is expected to have a useful life of 5 years, and the legal life of 7 years. The annual amortization charge will be $1,000 because the shortest period of 5 and 7 is 5 years and $5,000 / 5 years = $1,000. The effect of the purchase and amortization expense recognition for the first year is presented below:
Illustration 8-19: Effect of a trademark amortization on the horizontal model
| Assets |
= |
Equity |
Rev. |
- |
Exp. |
= |
Net |
Cash Flow |
|||||
| Cash |
+ |
Patent |
= |
Con. Cap. |
+ |
Ret. Earn. |
|||||||
| (5,000) |
+ |
5,000 |
= |
n/a |
+ |
n/a |
n/a |
- |
n/a |
= |
n/a |
(5,000) |
IA |
| n/a |
+ |
(1,000) |
= |
n/a |
+ |
(1,000) |
n/a |
- |
(1,000) |
= |
(1,000) |
n/a |
|
The journal entries are shown below:
Illustration 8-18: Journal entries for trademark acquisition and amortization expense
| Event No |
Account titles |
Debit |
Credit |
| 1 |
Patent |
5,000 |
|
|
|
Cash |
|
5,000 |
| 2 |
Amortization Expense |
1,000 |
|
|
|
Patent |
|
1,000 |
Note that the Patent account was affected directly by the expense recognition; however, a contra asset account Allowance for Amortization could have been used.
Goodwill is the added value of a business because of favorable factors such as good reputation, location, etc. Specifically identifiable indefinite life assets are those for which a company cannot determine the useful life or such assets do not have a definite useful life.
Both goodwill and indefinite life intangibles are not amortized because there is no enough information to make required calculations. However, such assets are subject to impairment testing. We do not review accounting for goodwill and indefinite life intangibles here because they are usually explained in accounting courses above the principles level.
It is important to note that depreciation for property, plant, and equipment; depletion for natural recourses; and amortization for intangible assets are simply different terms used to refer to the process of expense allocation of different types of long-term assets.
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