Amortization of Intangible Assets | CFA Level I FSA
Understanding Amortization and Intangible Assets
Amortization is the process of allocating the cost of intangible assets over their useful lives, similar to depreciation for tangible assets. Intangible assets are long-lived assets without physical substance, and they can be classified as finite-life or indefinite-life assets, as well as identifiable or unidentifiable.
Finite-Life vs. Indefinite-Life Intangible Assets
- Finite-Life Intangible Assets: Examples include patents, copyrights, and franchises. These assets are amortized over their useful lives.
- Indefinite-Life Intangible Assets: Examples include brand names and reputation. These assets are not amortized but are tested for impairment at least annually. If impaired, the reduction in value is recognized as a loss in the income statement.
Identifiable vs. Unidentifiable Intangible Assets
- Identifiable Intangible Assets: These assets can be separated from the firm, arise from a contractual or legal right, are controlled by the firm, and are expected to provide future economic benefits.
- Unidentifiable Intangible Assets: These assets cannot be purchased separately and may have an indefinite life. The most common example is goodwill, which represents the excess of the purchase price over the fair value of the identifiable assets acquired in a business combination.
Amortization methods for intangible assets are identical to depreciation methods for tangible assets, including straight-line, accelerated, and units-of-production methods. The total amount of amortization is the same under all methods, with only the timing of the expense in the income statement differing.
Accounting for Intangible Assets
Accounting for intangible assets depends on whether they were created internally, purchased externally, or obtained as part of a business combination. In general, externally purchased assets and those obtained in a business combination are capitalized, while the costs to create intangible assets internally are expensed as incurred. However, there are exceptions, such as research and development costs and software development costs.
Research and Development Costs
- IFRS: Research costs are expensed as incurred, while development costs may be capitalized if certain criteria are met.
- U.S. GAAP: Both research and development costs are generally expensed as incurred.
Software Development Costs
- For Sale to Others: Costs are expensed as incurred until the product’s technological feasibility is established, after which the costs are capitalized.
- For Internal Use: Under U.S. GAAP, all development costs are capitalized, while under IFRS, the treatment is similar to software developed for sale.
Business Combinations and Goodwill
In a business combination, the purchase price is allocated to the identifiable assets and liabilities of the acquired firm based on their fair values. Any remaining amount is recorded as goodwill, an unidentifiable asset that cannot be separated from the business itself. Internally generated goodwill cannot be capitalized and must be expensed in the period incurred.
Amortization is the process of allocating the cost of intangible assets over their useful lives, and it plays a crucial role in accounting for these assets. Understanding the different classifications, methods, and accounting treatments for intangible assets is essential for financial statement analysis and decision-making. As you continue your studies, keep these concepts in mind and apply them to real-world examples to reinforce your knowledge.