What is Accumulated Amortization?
Accumulated amortization is an aggregated value of the amortization expense that has been recorded for an intangible asset based on the cost, lifetime and usefulness that has been allocated to the asset in producing the units, often viewed as the repayment that the firm would have to do to own the underlying intangible asset.
Accumulated Amortization Formula
Accumulated Amortization is an aggregated value and hence can be expressed mathematically as:
Example of Accumulated Amortization
Accumulated amortization is used to realize the value of intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. . Examples of these type of assets are:
- Exclusive contract
- Licensing agreement
An important point to note is that these values do diminish in value and eventually get to zero.
Consider the example of a patent. Let’s consider a major pharma firm ABC Healthcare headquartered in New York, the US, who spends a good amount of money on its Research and developmentResearch And DevelopmentResearch and Development is an actual pre-planned investigation to gain new scientific or technical knowledge that can be converted into a scheme or formulation for manufacturing/supply/trading, resulting in a business advantage. wing and comes up with a breakthrough drug that can help a deadly disease like cancer. This breakthrough has been the result of years of research by its R & D department.
The firm files a patent for this drug and holds exclusive rights for the next 10 years for 12 million dollars. During these 7 years, other firms and competitors are not allowed to produce this drug, although they can come up with a partnership with our firm but only at their discretion. However, the patent will expire and hence should be realized in the financials.
- Life of patent: 10 Years
- Total Value: $ 12 million
- Per Year AmortizationAmortizationAmortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset.: 12/10 = $ 1.2 million
Let’s design the cash flow for this expense, considering ABC healthcare follows a straight-line amortizationStraight-line AmortizationStraight-line amortization amortizes the cost of intangible assets or allocates the interest expenses associated with the bond's issue in each accounting period until the end of the intangible asset or maturity of bond respectively in the income statement. mechanism.
|Year||Amortization Expense||Accumulated Amortization|
This expense will continue to be part of the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. till 2029 post, which is completely amortized.
Refer to the given above excel sheet for detailed calculation.
Important Points to Note About Accumulated Amortization
- Often accumulated amortization is confused with depreciation. However, that’s not the case as the basic fundamental difference between the two is that amortization is used for intangible assetsIntangible AssetsAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets. For example, a company's land, as well as any structures erected on it, furniture, machinery, and equipment., while depreciation is used for tangible assets. Although the two are quite similar in how they are being accumulated and calculated.
- Amortization calculations have a direct effect on the firm’s financial statements, especially the bottom lineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its bottom line. . Hence it is very keenly watched by the investors to evaluate the firm’s financial health.
- As per current accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts. guidelines, it is imperative for a firm to evaluate its intangible assets as per current valuation at least once a year and record them as accumulated amortization. Advised by GAAP (Generally accepted accounting principlesGenerally Accepted Accounting PrinciplesGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors.), it is one of the ways through which the company adjusts its intangible assets to the fair value on the balance sheet as per the current market value.
- Accumulated amortization is similar to depreciation, with the only difference arising on what assets these have been applied. Both of these accounting methodsAccounting MethodsAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods. want to discount the value of assets that they possess in the company’s financial statements in a steady and regular manner, keeping the minimum effect on the short term as well as long term profits. On the one hand, depreciation is a mechanism to realize these values for tangible assets, accumulated amortization, on the other hand, is a mechanism to realize these values for intangible assets like licensing agreements, patents owned by the firm, list of customers to name a few.
- Accumulated amortization affects the net income as it reduces the retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company. acquired. To illustrate, a 50 million $ amortized value will reduce the revalue f retained earnings by the same amount.
- Amortization draws many parallels from depreciation. One of those is how these can be calculated and recorded on the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.. There can be three different methods through which amortization can be calculated. Irrespective of the methods used, it is imperative to understand the usefulness of the intangible asset, its residual value, and its impact on actual production and distribution costsDistribution CostsDistribution cost is the total of all expenses incurred by the producer to make possible the delivery of the product from its location to the location of the end customer..
- Straight-line Method: Similar to the straight-line method of depreciationStraight-line Method Of DepreciationStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. , it calculates the total amortization cost and divides it by the time horizon. Thus, providing a gradual and even decay of the intangible asset.
- Accelerated Method: This method follows a weighted average approach and provide more value in earlier years and reduces with each passing year. This is based on the economic principle of the law of diminishing marginal utilityLaw Of Diminishing Marginal UtilityThe law of diminishing marginal utility states that the amount of satisfaction provided by consuming every additional unit of goods decreases as we increase that goods consumption. Marginal utility is the change in the contentment derived from consuming an extra unit of goods. as with each year gains realized are less than what was achieved last year.
- Units of Production Method – This method allocates the cost in the ratio in which this intangible asset was helpful in producing the actual units.
- Often accumulated amortization is presented as a separate item on the balance sheetItem On The Balance SheetAssets such as cash, inventories, accounts receivable, investments, prepaid expenses, and fixed assets; liabilities such as long-term debt, short-term debt, Accounts payable, and so on are all included in the balance sheet. as a common industry practice. Another way of looking at it can be realizing it as a contra asset account.
Accumulated amortization is a useful mechanism to evaluate the value of intangible assets and the usefulness they provide to the firm. However, the point to note is that not all intangible assets can be amortized. Consider the case of patents and licensing agreements. These methods help in evaluating the competitive edge that firm gains in comparison to its peers and how it can use it present its financials in a better way to its shareholders.
Now consider the case of another intangible asset, Goodwill. GoodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price., as we know, is a measure of the synergy capacity that the firm has acquired over a time frame as a result of acquisitions. Hence goodwill should never be amortized as this value should always increase. In fact, much like land, which is never depreciated, it should be reviewed once a year to provide a better and current view of the underlying assetThe Underlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.. One should see it as having an indefinite life and always adding value to the firm’s financials.
This has been a guide to Accumulated Amortization. Here we discuss formula to calculate the accumulated amortization along with an example and its importance. You can learn more about accounting from the following articles –