What Is the Cost Allocation Method for Intangible Assets?

Businesses acquire resources to operate and grow. As resources are consumed, their value declines. Accounting for this decline accurately represents a company’s financial performance and position. Spreading the cost of these items over their benefit period provides a clearer picture of profitability by matching the expense of using an asset with the revenue it helps generate.

Understanding Intangible Assets

Intangible assets are non-physical resources that provide long-term economic benefits to a company. They lack a physical form but hold value due to the rights they confer or the competitive advantages they provide. These assets are often developed internally or acquired from other entities. They are recorded on a company’s balance sheet at their acquisition cost.

Common examples include patents, which grant exclusive rights to an invention, often for 20 years in the United States. Copyrights protect original works of authorship, generally for the author’s life plus 70 years. Trademarks, such as brand names and logos, can be renewed indefinitely and represent significant brand recognition. Goodwill, another intangible asset, arises when one company acquires another for a price exceeding the fair value of its identifiable net assets. The value of these assets diminishes not from physical wear, but from legal expiration, obsolescence, or market shifts.

Amortization: The Cost Allocation Method

The specific accounting method used to spread the cost of an intangible asset over its useful life is called amortization. Amortization systematically reduces the recorded value of an intangible asset on the balance sheet while simultaneously recognizing an expense on the income statement. This process aligns with the matching principle, an accounting concept that dictates expenses should be recognized in the same period as the revenues they help produce.

The “useful life” of an intangible asset refers to the period during which it is expected to contribute to a company’s future cash flows. This useful life can be determined by legal or contractual terms, such as the 20-year term for a utility patent, or by economic factors like anticipated obsolescence. For financial reporting purposes under generally accepted accounting principles (GAAP), an intangible asset with a finite useful life is amortized. Assets with an indefinite useful life, like certain trademarks or goodwill, are not amortized but are instead reviewed periodically for impairment, meaning a potential decline in value.

For federal income tax purposes in the United States, the Internal Revenue Code Section 197 provides specific rules for amortizing certain acquired intangible assets. Many acquired intangibles, including goodwill, covenants not to compete, customer lists, and trademarks, are amortized evenly over a 15-year period for tax deduction purposes. This 15-year tax amortization period applies regardless of the asset’s actual estimated useful life for financial reporting.

Calculating Amortization

The common method for calculating amortization is the straight-line method. This approach allocates an equal amount of the asset’s cost to each period over its useful life. The formula for straight-line amortization is: (Cost of Intangible Asset – Residual Value) divided by the Useful Life. For most intangible assets, the residual value, which is the estimated value at the end of its useful life, is considered zero. This is because intangible assets have no remaining value after their legal or economic benefits expire.

To illustrate, if a company acquires a patent for $100,000 with a useful life of 10 years and no residual value, the annual amortization expense would be $10,000 ($100,000 / 10 years). Each year, this $10,000 is recorded as an expense on the income statement, reducing the company’s net income. Concurrently, the accumulated amortization, which is the total amortization expensed to date, increases on the balance sheet, thereby reducing the asset’s carrying value. Other amortization methods exist, but these are less frequently applied to intangible assets.

Amortization Versus Depreciation

Both amortization and depreciation are systematic cost allocation methods designed to spread the cost of an asset over its useful life. Their purpose is to match the expense of using an asset with the revenues it helps generate. Both processes reduce the asset’s value on the balance sheet and create an expense on the income statement, ultimately impacting a company’s reported profitability. These methods are to accrual accounting, which recognizes revenues and expenses when they are incurred, regardless of when cash is exchanged.

The distinction between the two terms lies in the type of asset to which they apply. Amortization is exclusively used for intangible assets, which lack physical substance. This includes items like patents, copyrights, trademarks, and goodwill.

Conversely, depreciation is the term used for allocating the cost of tangible assets, which are physical assets that can be touched and seen. Examples of tangible assets include buildings, machinery, vehicles, and office equipment. The different terminology reflects the distinct ways these asset types decline in value; tangible assets wear out or become obsolete physically, while intangible assets expire legally or economically.