Amortization reduces the stated value of intangible assets which, as a rule, have no physical substance but add benefits to a business. In essence, amortization defines the consumption of value of the purchased intangible assets. Through amortization, the costs are spread over the useful life of assets. The costs are allocated in a rational manner for a period that is expected to accumulate benefits from the utilization of intangible assets. In other words, the owners of a business prepay the expenses before the actual use of the assets. In order to qualify for amortization, the assets have to match three requirements. They need to have determinable or measurable value. Their useful life must exceed one year in length. Thirdly, intangible assets are typically separate from goodwill.
The terms amortization and depreciation are sometimes used interchangeably. However, amortization refers to intangible assets such as franchise licences, patents, trademarks, and other non-monetary assets. Depreciation, on the other hand, refers to tangible assets which have actual physical existence (land, facilities, and equipment).
Accountants apply two methods to calculate amortization. The Units of Activity Method requires that the intangible asset is consumed in a production pattern. In contrast, the Straight-Line Method is used when the asset is not consumed in a production pattern.
The process of amortization will be illustrated by the purchase of a patent which gives the right to produce or sell innovative products. This patent has a legal life of seventeen years. We should note that similarly to other intangible assets, patents are fully amortized prior to the end of their legal life. We set the price of the patent at $ 200.000. However, the purchasing company believes that this sum exceeds the useful life of the asset. Then, the investor may estimate that the useful life of the patent is only ten years. He will utilize the Straight-Line Method to calculate that the amortization amounts to $ 20.000 each year. Basically, he will divide the total sum by the number of years in order to record the amortization per year. He can debit the amortization expenses for $ 20.000 and credit the accumulated amortization by the same amount. Similar entries will be recorded to account for the amortization of other intangible assets. The amount can be calculated by amortization charts, software packages, and financial calculators.
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