What is Accumulated Amortization?
Accumulated amortization is the total sum of amortization expense recorded for an intangible asset. In other words, it’s the amount of costs that have been allocated to the asset over its useful life.
A lot of people confuse amortization with depreciation. Although both are similar concepts, depreciation is used for physical assets like fixed assets whereas amortization is used for intangible assets like patents.
Both Fixed assets and intangible assets are capitalized when they are purchased and reported on the balance sheet. No costs are initially recorded on their purchase dates. Instead, the assets’ costs are recognized ratably over the course of their useful life. This cost allocation method agrees with the matching principle since costs are recognized in the time period that the help produce revenues.
The accumulated amortization account is a contra asset account that is used to lower the book value of the intangible assets reported on the balance sheet at historical cost. Accumulated depreciation is usually presented after the intangible asset total and followed by the book value of the assets. This presentation shows investors and creditors how much cost has been recognized for the assets over their lives. Conversely, it also gives outside users an idea of the amount of amortization costs that will be recognized in future periods.
Amortization refers to capitalizing the value of an intangible asset over time. It’s similar to depreciation, but that term is meant to refer more to a tangible asset (a piece of equipment or office furniture that a company might purchase). Amortization occurs when the value of an asset (usually an intangible asset, like R&D or a trademark) is reduced over a specific time period, which is usually the asset’s estimated useful life.
A good way to think of this is to consider amortization to be the cost as the asset is consumed or used up while generating sales or profits for a company. Along with useful life, major inputs into the amortization process include residual value and the allocation method, the last of which can be on a straight-line basis that is mostly straightforward.
A more specialized case of amortization takes place when a bond that is purchased at a premium is amortized down to its par value as the bond reaches maturity. (When a bond is purchased at a discount, the term is called accretion.) The concept is again referring to adjusting value overtime on a company’s balance sheet, with the amortization amount reflected in the income statement.
A rule of thumb on this is to amortize an asset over time if the benefits from it will be realized over a period of several years (or longer). With a short expected duration (such as days or months), it is probably best and most efficient to expense the cost through the income statement, and not count the item as an asset at all.
A Little More on What is Accumulated Amortization
In accounting, accumulated amortization refers to the sum allocated to an asset from when it started being used to the period it was quantified. The allocation of sum or cost is done periodically.
A taxpayer, a corporate tax or income tax firm can also claim accumulated amortization. This is the depreciated deducted from an asset. However, accumulate amortization in both accounting and tax might have the same sum of have different sums. This is based on certain factors such as when depreciations are yet to be deducted from tax expense.
As mandated by the Commercial code, employers are obligated to keep accounts for accounting and tax purposes. Employers are obliged to carry out the following tasks:
- Keeping accounts of all business activities in an orderly manner. This will enhance a proper assessment of inventories and balance sheets.
- This recording of accounting must be carried out by authorized persons in the company.
- The employer must record agreements by the General and Special Boards and the other collegiate bodies of the company. This means that the employer must have a record of minutes of meeting reflecting matters debated, interventions and resolutions.
- The sum of periodic allocation of amortization should also be accounted for because this makes up a cumulative amortization.
A cumulative amortization is also an accumulated amortization, it is arrived at when all the amortization expenses of an asset is calculated. It is calculated after the depreciation deductions and other tax obligations have been met. The cumulative amortization determines the income that will be under personal income tax.
The personal income tax describes the amount that is deductible as amortization expense of asset which determine the net return of economic activities performed by the assets. The corporate tax on the other hand is a fiscally deductible tax expense that determines the bases of tax at different tax periods when the assets are still being managed.
What Does Accumulated Amortization Mean?
When an organization acquires an intangible asset that depletes in value over time, it is necessary to reduce its value in the company’s balance sheet in a gradual manner. This is done by debiting the amortization expense account and crediting the accumulated amortization account.
The amortization of the intangible asset is completed over its useful life. Amortization is similar to depreciation, but there is one crucial difference. Tangible assets like machinery, equipment, and buildings are depreciated. However, amortization is always carried out with reference to intangible assets.
Examples of intangible assets are:
- Noncompetition agreements
- Customer lists
- Licensing agreements
- A patent is an exclusive right granted by the government to manufacture a certain product for 17 to 20 years. During this time, other manufacturers are not permitted to make the same product. This “right” or patent is an intangible asset owned by the company.
But as the patent will expire in some years, it is necessary that an amortization expense is recorded in the company’s income statement every year. It should be remembered that amortization is usually calculated on a straight-line basis. The total of this amount is referred to as accumulated amortization.
The accumulated amortization amount is reduced from the intangible asset’s value in the company’s balance sheet.
Alan’s Engineering is a company that creates software packages for engineering firms. It has numerous register trademarks, copyrights, and patents for its work. A new project costing $20,000 was completed this year and obtained a patent with 20-year life.
At the end of the first year, Alan will debit amortization expense and credit accumulated amortization for $1,000 (total purchase price divided by useful life in years). Alan will make this journal entry every year to the record the current amortization expense and cumulative expense over the life of the asset. The current expense will be reported on the income statement and the updated accumulated total will be reported on the balance sheet each year.
It is important to note that the accumulated amortization of assets is generally limited to certain long term assets when it comes to Accounting Principles.
First, there are patents; patents grant the owner exclusive privileges to production over a long-term period of time.
Then, there are copyrights. Copyrights give the owner the right to reproduce a product for a period of time. There are also trademarks that are the “faces” of a company for years (e.g the “whopper” for Burger King).
Finally, there are licenses that give an organization or person the right to perform a certain act or sell a certain product. There are leaseholds that are payments to ensure that an asset will be sold from a lessor.
Amortize all of these examples in accordance with their amortization rate and how long the agreement actually lasts.
Accumulated Amortization Calculation
Now, you know the types of accounts amortized. So, observe a particular example of accumulated amortization in a real world situation.
For example, Burger King wants to patent a new breakfast pancake sandwich called the “flopper”. Burger King wishes to purchase a patent on the sandwich for $500,000. The company believes that the patent is going to be useful for 5 years. The regular journal entry for the patent is simple with a debit to the patent matched with a credit to cash. In order to correctly amortize the patent, record a separate debit as “amortization expense” for the patent. Then, match it with a credit that matches with the debit for the patent recorded earlier.
To determine the amount for the patent, simply take the amount required to purchase the patent. Then divide it by the number of years used for (in this case $100,000/yr).
GAAP Versus IFRS
Firms must account for amortization as stipulated in major accounting standards. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) both have similar definitions of what qualifies as an intangible asset, but there are differences in how their values must be adjusted over time.
For instance, development costs to create new products are expensed under GAAP (in most cases) but capitalized (amortized) under IFRS. GAAP does not also allow for revaluing the value of an intangible, but IFRS does. This means that GAAP changes in value can be accounted for through changing amortization schedules, or potentially writing down the value of an intangible, which would be considered permanent. Finally, GAAP stipulates that advertising expenditures be expenses as incurred, but IFRS does allow recognizing a prepayment of these expenses as an asset, which would be capitalized or amortized as they are used at a later date.