Amortization of Intangible Assets

Amortization of intangible assets is the systematic process of moving the recorded cost of an intangible asset — such as a patent, trademark license, customer relationship, or non-compete agreement acquired in a deal — from the balance sheet onto the income statement as amortization expense, spread across the periods the asset is expected to provide economic benefit.

The first step is estimating how long the intangible asset will actually contribute value: a patent's useful life might be capped by its legal term, a customer list's useful life might be estimated from historical customer attrition rates, and a favorable lease might be amortized over the remaining lease term. Once a useful life is established, the asset's cost is typically spread evenly across it using the straight-line method, unless a company can demonstrate that a different pattern, such as accelerated amortization matching an expected decline in the asset's revenue contribution, better reflects how the asset's benefit is actually consumed.

Not all intangible assets are amortized. Those with an indefinite useful life — goodwill being the most common example, along with some trademarks a company intends to renew indefinitely — are instead tested periodically for impairment rather than amortized on a schedule, since there is no way to estimate a useful life for an asset management does not expect to ever stop benefiting from.

Each period, the company debits amortization expense and credits either the intangible asset account directly or a contra-asset accumulated amortization account, reducing the asset's carrying value. By the end of the asset's estimated useful life, its carrying value has been reduced to its estimated residual value, which for most intangible assets is assumed to be zero.

Because amortization is a non-cash expense, it reduces reported net income without any cash leaving the business in that period, which is why it is added back to net income when calculating cash flow from operations on the statement of cash flows. Companies that have made several acquisitions often carry a large balance of intangible assets acquired in those deals, and the resulting amortization expense can be a significant, non-cash drag on reported earnings for years, which is one reason many analysts look at operating metrics that add amortization of acquired intangibles back, to judge the underlying cash-generating performance of the business separately from the accounting effects of its acquisition history.

A company that pays $240,000 for a customer list with an estimated 8-year useful life would record $30,000 of amortization expense per year under the straight-line method. After three years, the asset's book value would have fallen to $150,000, with the remaining $90,000 to be amortized over the five years left in its estimated useful life, assuming no indication of impairment arises in the meantime.

Estimating an intangible asset's useful life is often harder than estimating useful life for a tangible asset like machinery, since the limiting factor is rarely physical wear and tear. A customer relationship might be amortized over the average expected customer retention period; a patent is typically amortized no later than its remaining legal protection period, even if management believes it could generate value longer; and a non-compete agreement is amortized over its contractual term. Straight-line amortization is used unless a company can reliably demonstrate that the economic benefits of the asset are consumed in a different pattern — for example, a customer list might reasonably be amortized on an accelerated basis if attrition is known to be heaviest in the first few years after acquisition.