What it means
Intangible assets, such as patents, software licences, customer lists and trademarks, give a business benefits over several years. Instead of charging the full cost to expense on the day of purchase, the business spreads it over the asset's useful life.
That yearly charge is called amortisation, and the running total of all the charges to date is accumulated amortisation. The balance sheet shows the intangible asset at its original cost, with accumulated amortisation deducted underneath.
The difference is the net book value, which falls each year until the asset is fully amortised or sold. Keeping cost and accumulated amortisation separate lets readers see how old and how heavily used the asset is.
Most companies use the straight-line method, which spreads the cost evenly across the useful life. The useful life is an estimate based on legal protection, technology and expected use, and it should be reviewed if conditions change.
Some intangibles with an indefinite life, such as certain brand names, are not amortised but are tested for impairment (a write-down when the asset has lost value). Accumulated amortisation is a contra-asset account, meaning it carries a credit balance that reduces an asset.
It is not a cash reserve, and no money is set aside when amortisation is recorded. It is a bookkeeping record of the cost already used up.
Analysts look at the ratio of accumulated amortisation to cost to judge how close intangible assets are to the end of their lives. A high ratio suggests that the company will soon need to renew or replace them, which may require cash.
When an asset is sold or scrapped, its accumulated amortisation is removed together with its cost. Acquired intangibles are common in company takeovers.
When a buyer purchases a business, it often records customer relationships, technology and brand names at fair value and amortises them over their lives. That is why the profits of an acquisitive company can carry a large amortisation charge that has nothing to do with day-to-day operations.
In practice
Real-world examples
Example 1
A pharmaceutical company buys a patent for a drug formulation. It amortises the cost evenly over the remaining 12 years of patent protection. Each year, the charge reduces profit and increases the accumulated amortisation shown on the balance sheet, although no cash leaves the business.
Example 2
A marketing agency pays $60,000 for customer-management software with a five-year licence. It records $12,000 of amortisation each year. After three years, the accumulated amortisation is $36,000 and the net book value is $24,000.
Example 3
A publisher buys the rights to a catalogue of books for $450,000 and expects them to generate sales for 15 years. Annual amortisation is $30,000. When the rights are sold in year 9 for $200,000, the company compares the sale price with the net book value of $180,000 to find the gain of $20,000.
Think of it
Accumulated amortization is the running total of how much you've written off an intangible asset.
Formula
Calculation
Annual amortisation = (Cost - Residual value) / Useful life
Accumulated amortisation = Annual amortisation x Years elapsed
Net book value = Cost - Accumulated amortisation
A company buys a patent for $300,000 with no residual value and an expected life of 10 years. Annual amortisation = $300,000 / 10 = $30,000. After 4 years, accumulated amortisation = $30,000 x 4 = $120,000, and net book value = $300,000 - $120,000 = $180,000.Case study
Seen in the real world
Brightpath Software is a fictional company that, in this illustrative story, bought the source code for a specialised scheduling tool for $500,000. The finance team estimated a useful life of five years, giving annual amortisation of $100,000.
At the end of year three, accumulated amortisation was $300,000 and the net book value was $200,000. The product team then announced that a newer platform would replace the tool within a year, so the remaining useful life was much shorter than expected.
The finance manager reviewed the life and shortened it, which meant the remaining $200,000 would be amortised over the next year, not two. The profit for that year fell, but the balance sheet no longer showed an asset that would soon have no value. The auditors welcomed the prompt review.
Watch out
Common mistakes
- Treating accumulated amortisation as cash saved for replacement. It is only an accounting record of cost already expensed.
- Confusing amortisation with depreciation. Amortisation applies to intangible assets and depreciation to physical ones, although the method is similar.
- Amortising an asset past the end of its legal or useful life. The charge should stop when the carrying value reaches the residual value.
Questions
People also ask
Is accumulated amortisation an asset or a liability?
It is a contra-asset, which reduces the carrying value of an intangible asset. It sits within the asset section of the balance sheet.
What happens to accumulated amortisation when an asset is sold?
It is removed along with the asset's original cost, and the difference between the sale price and net book value is recorded as a gain or loss.
Does accumulated amortisation affect tax?
Often yes, since many tax systems allow amortisation as a deduction, although the rules and periods can differ from the accounts, so a company often keeps a separate tax schedule.
Watch