Bookkeeping – Amortization (Lesson 53)

Amortization is similar to depreciation whereby an asset’s cost is allocated to the expense over time. There are several differences with amortization. Amortization is used with intangible assets and the method is almost always straight line. As a bookkeeper it is your job to maintain the amortization schedules, report the information correctly and interpret the results for management. This lesson will explain the intangible asset and the account structure for accounting purposes. In addition, the respective methods are explained along with reporting systems. Finally I’ll provide two of the most common small business assets that are amortized and illustrate how this is done.

Intangible Assets

Fixed assets are defined as tangible (physical in nature) and long-lived purchases. Think of real estate, equipment, trucks and computers. Intangible assets are similar in that they have long lives (value into the future) but have no physical form other than as a piece of paper. Examples of intangible assets include:

  • Patents/Copyrights/Brand and Logo
  • Legal Contractual Rights (Employment Agreements, Options etc.)
  • Organizational Costs
  • Goodwill
  • Investment into a Website
  • Financing Costs
  • Research and Development

The intangible asset is put to work to assist the company in making money. A good example is when a major pharmaceutical company spends millions of dollars over several years to end up with a formula for a new drug. This investment is accumulated into research and development (R&D). Once it is FDA (Food and Drug Administration) approved, this accumulated value is then amortized over the expected life of the drug (the expected earnings period which is often 20 to 40 years).

Just like fixed assets, intangible assets are reported on the balance sheet in the assets half of the report. Within the asset’s half of the balance sheet there are three distinct sections: 1) Current Assets, 2) Fixed Assets and 3) Other Assets. Intangibles are reported in the other assets section as illustrated here:

                               XYZ COMPANY
                     Balance Sheet – Limited Scope
                         Other Assets Section Only
                                     Date
OTHER ASSETS
Land Held for Future Use                                $ZZ,ZZZ
Non-Current Assets:
  – Inventory                                      $Z,ZZZ
  – Long-Term Receivables                 Z,ZZZ
  – Warranties                                      Z,ZZZ
  – Deposits                                             ZZZ
     Sub-Total Non-Current                                  ZZ,ZZZ
Intangibles:
  – Organizational Costs                    $Z,ZZZ
  – Legal Rights                                   Z,ZZZ
  – Financing Costs                              Z,ZZZ
  – Accumulated Amortization           (Z,ZZZ)
     Sub-Total Intangibles                                       Z,ZZZ
TOTAL OTHER ASSETS                                $ZZ,ZZZ

Just like fixed assets have accumulated depreciation to offset the cost of fixed assets, intangibles have accumulated amortization to offset costs. Also, intangibles are often set up in a parent-child account structure. Remember the above account structure is set up via the chart of accounts.

Amortization Methods and Reporting

One of the interesting aspects of intangible assets is their lack of substantiated history as to value. Physical assets have engineering and historical evidence to vouch their expected life. Intangibles generally do have these attributes. Educated guesses are used based on what is known. Often the source document provides the necessary evidence. A good example is a legal agreement to use a particular right. The contract may state “… will expire on January 24, 2022”. This clearly identifies a time period. But most intangibles require outside law or custom to establish the time period. Here are some general guidelines:

* Patents/Copyrights/Branding        80 Years
* Organizational Costs                       5 Years
* Goodwill                                        40 Years
* Website Development                      5 Years
* Training                                            5 Years
* Research and Development            20 Years

Because there is so much unknown as it relates to intangibles the amortization method is rarely accelerated; instead, straight line amortization is utilized. There are some exceptions especially for goodwill, so consult with the company’s CPA for guidance related to goodwill.

The bookkeeper keeps schedules for amortization in a similar format as depreciation schedules. The only difference is that there are no tax preference items as the Internal Revenue regulations only authorize straight line amortization for intangible assets. In reality, amortization schedules are easier to prepare and track.

Just like depreciation the best convention is mid-month requiring pro-rated amounts for the first and last year of amortization of the asset.

The entry for amortization is customarily tracked in the fixed assets journal including the original cost basis of the intangible item. I can’t explain why this journal is used but I believe it is because of the dollar value involved in the initial financial outlay. The entry for amortization is usually monthly and it is a recurring amount. Here is a typical entry:

Fixed Assets Journal
Date         ID      Ledger            Description                                                           DR                 CR
Today   A9/07    Amortization    Monthly Amortization of Financing                   $42.10
                                                    Costs; See Sched A9 Loan #7647
             A9/07    Accum. Amort. Monthly Amortization Intangible Asset A9                              $42.10
                                                                                                                                 $42.10            $42.10

Amortization is reported on the income statement (profit and loss statement) in the capital costs section of expenses. This is the reporting outline for the income statement’s expense section in summary except for the capital costs segment.

                                            XYZ COMPANY
               Income Statement – Limited Scope Presentation
                     For the Month Ending March 31, 2017

Revenues                                                     $ZZZ,ZZZ
Cost of Sales                                                    ZZ,ZZZ
Gross Profit                                                     ZZ,ZZZ
Expenses:
     Management                          $ZZ,ZZZ
     Facilities                                    Z,ZZZ
     Insurance                                   Z,ZZZ
     Office Operations                      Z,ZZZ
     Taxes and Licenses                   Z,ZZZ
     Other                                            ZZZ
     Capital Costs:
        Leases                        $ZZZ
        Interest                         ZZZ
        Depreciation             Z,ZZZ
        Amortization                ZZZ
        Sub-Total Capital Costs          Z,ZZZ
      Sub-Total Expenses                                   ZZ,ZZZ

Operational Profit                                             $Z,ZZZ

Notice amortization is after depreciation in the report? Most accountants advocate keeping depreciation and amortization right next to each other. This assists a reader of financial statements with interpreting the information.

Interpreting Amortization

A common misconception is that all intangible assets have intrinsic value. This is FALSE. Some intangible assets do have value as long as that right is transferable. As an example, a trust buys the right to use a piece of land for 60 years. This is an intangible asset because it is a legal document. Thirty years into the agreement, the trust is considering options to sell this asset. With 30 years remaining there is obviously value with this right. Value does exist with some intangible assets.

Now think of the organizational costs of the company. The company paid out $10,000 for legal structure. Partnership agreements, application fees and initial director meeting costs to create the company were expended. For an outsider looking at the company to buy its assets (remember organizational costs are recorded as an intangible asset on the balance sheet under other assets) organizational costs are worth zero dollars. Here is a short list of intangible assets and valuation application.

      Intangible Asset                           Valuation
      Organizational Costs                      None
      Patents/Copyrights/Branding         Yes
      Legal Documents (Corporate)        Generally None
      Goodwill                                        Yes; but independently appraised
      Contract Rights                              Yes
      Website Development                    None
      Research and Development           Generally None

Overall accountants ignore the value of intangible assets when evaluating the overall financial picture of the company. These assets only have value as long as the company continues to operate from year to year (referred to as a ‘going concern’). In addition banks ignore this value too when reviewing financial assets of a small business.

The balance sheet in summary format reports intangibles as ‘Intangibles Net of Amortization’ i.e. both cost basis and accumulated amortization combined in a single value. In a detailed presentation format, the balance sheet presents both the cost basis and accumulated amortization. Obviously the detailed format is more informative than the summary format.

Just like fixed assets accountants will present notes to the financial statements identifying major intangible assets and the corresponding accumulated amortization to date against that asset. In addition a short schedule identifies the expected accumulated amortization amount per year for the next five years and the remaining amount for all years after five.

Examples

To illustrate amortization the following two examples provide insight into how amortization is conducted.

Organizational Expenses

When a company starts up there are some initial costs to get the legal status completed. This customarily includes legal counsel costs, CPA tax guidance charges, state fees, document fees and cost to subscribe and admit directors along with the costs of a meeting. For the average small business it runs upwards of $5,000. This initial cost is expensed via amortization over five years or more.

The initial entry is recorded in the fixed assets journal with a debit to an account created in other assets called organizational set-up. The credit is usually to cash as all these expenses are customarily paid with cash. For this example, the initial organizational costs are $3,285. Over on the balance sheet it looks like this in the other assets section.

OTHER ASSETS
Intangibles:
   – Organizational Set-Up         3,285
   – Other Intangibles                Z,ZZZ
      Sub-Total Intangibles                    $ZZ,ZZZ

As is customary with organizational costs, a 60 month period of amortization is expected using a mid-month convention. The calculated monthly amortization is $54.75.  So a 1/2 month amount equals $27.38. After three calendar months, accumulated amortization is $136.88 ($27.38 + 54.75 + 54.75). Now this section of the balance sheet looks like this:

OTHER ASSETS
Intangibles:
     – Organizational Set-Up                        $3,285
     – Other Intangibles                                 Z,ZZZ
     – Accumulated Amortization                    (137)
        Sub-Total Intangibles Net of Amortization      $ZZ,ZZZ

Notice the wording and the fact that a credit balance account exists with an asset type of account. As explained in Lesson 13, parenthesis are used with the balance sheet presentation to identify a offsetting value for the respective item; in this case a credit based value in a traditionally debit balance account.

Training

This same company is considering status as a franchise operation. Before signing an agreement the franchise requires training of managers. The course, transportation and incidentals cost $8,000 to complete. When signed, the franchise agreement requires additional training every seven years. The training is amortized over seven years. The monthly amortization is $95.24. The first month is $47.62 due to the mid-month convention. Three months after training the accumulated amortization for training is $238.10. The balance sheet looks like this:

OTHER ASSETS
Intangibles:
   – Organizational Set-Up                         $3,285
   – Franchise Training                                 8,000
   – Accumulated Amortization                     (539)
      Sub-Total Intangibles Net of Amortization       $10,746

Why is accumulated amortization $539? There are two items being amortized. The first is organizational set-up with five and half months of amortization (2.5 months from the example above plus 3 more); the second is the 2.5 months of training at $238.10.   Here is a table for the two assets:

Intangible                        Cost                              Accumulated  Unamortized
Intangible                       Basis       Months   $/Month       Amount         Balance
  Organizational Set-up   $3,285        5.5           54.75           $301.13        $2,983.87
  Franchise Training          8,000        2.5           95.24             238.10          7,761.90
                                       $11,285                                            $539.23     $10,745.77

Summary – Amortization

Amortization is a process of allocating the cost basis of intangible assets over time to the income statement. The process is very similar to depreciation except the straight-line method is the standard used. Intangible assets are recorded to the other assets section of the balance sheet. Actual amortization costs are debited to an account in the capital costs section of the income statement. The end result is a more fairly stated financial position for the company. Act on Knowledge.

Value Investing

Do you want to learn how to get returns like this?

Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.

There are four key principles used with value investing. Each is required. They are:

  1. Risk Reduction – Buy only high quality stocks;
  2. Intrinsic Value – The underlying assets and operations are of good quality and performance;
  3. Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
  4. Patience – Allow time to work for the investor.

If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above. 

Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:

  1. Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
  2. Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
  3. Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.

Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:

  • Lessons about value investing and the principles involved;
  • Free webinars from the author following up the lessons;
  • Charts, graphs, tutorials, templates and resources to use when you create your own pool;
  • Access to existing pools and their respective data models along with buy/sell triggers;
  • Follow along with the investment fund and its weekly updates;
  • White papers addressing financial principles and proper interpretation methods; AND
  • Some simple good advice.

Value Investment Club

Please Signup
*
Username
Username can not be left blank.
Please enter valid data.
This username is already registered, please choose another one.
This username is invalid. Please enter a valid username.
*
First Name
First Name can not be left blank.
Please enter valid data.
This first name is invalid. Please enter a valid first name.
*
Last Name
Last Name can not be left blank.
Please enter valid data.
This last name is invalid. Please enter a valid last name.
Website (URL)
Website (URL) can not be left blank.
Invalid URL
Invalid URL
*
Email Address
Email Address can not be left blank.
Please enter valid email address.
Please enter valid email address.
This email is already registered, please choose another one.
*
Password
Password can not be left blank.
Please enter valid data.
Please enter at least 6 characters.
    Strength: Very Weak
    Select Your Payment Gateway
    How you want to pay?
    Payment Summary

    Your currently selected plan : , Plan Amount :
    , Final Payable Amount:
    Submit
    Please follow and like us: