Explaining amortization in the balance sheet

A few years ago, in rather significant fashion, the U.S. Bureau of Economic Analysis announced a change to the way it estimates gross domestic product (GDP). Going forward, it was going to include a non-physical or intangible asset, research and development (R&D) in its calculations of investments in the economy. The change boosted economic growth several basis points over the last 50 years and made the economy nearly $560 billion larger than previously estimated. Now that it is considered a long-lived asset in the economy accountants will have to measure whether to adjust or amortize the amount over time.

Amortization is an important concept not just to economists, but to any company figuring out its balance sheet. We explain it in more detail below.

Amortization refers to capitalizing the value of an intangible asset over time. It's similar to depreciation, but that term is meant to refer more to a tangible asset (a piece of equipment or office furniture that a company might purchase). Amortization occurs when the value of an asset (usually an intangible asset, like R&D or a trademark) is reduced over a specific time period, which is usually the asset's estimated useful life.

A good way to think of this is to consider amortization to be the cost as the asset is consumed or used up while generating sales or profits for a company. Along with useful life, major inputs into the amortization process include residual value and the allocation method, the last of which can be on a straight-line basis that is mostly straightforward.

A more specialized case of amortization takes place when a bond that is purchased at a premium is amortized down to its par value as the bond reaches maturity. (When a bond is purchased at a discount, the term is called accretion.) The concept is again referring to adjusting value over time on a company’s balance sheet, with the amortization amount reflected in the income statement.

A rule of thumb on this is to amortize an asset over time if the benefits from it will be realized over a period of several years (or longer). With a short expected duration (such as days or months), it is probably best and most efficient to expense the cost through the income statement, and not count the item as an asset at all.

Other examples of intangible assets include customer lists and relationships, licensing agreements, service contracts, computer software and trade secrets (such as the recipe for Coca-Cola). Goodwill is another major intangible asset. It used to be amortized over time, but now must be reviewed annually for any potential adjustments.

The best example of how this can impact a company’s financials in a big way is the purchase of Time Warner in 2000 by America Online (AOL) during the dot-com bubble. AOL paid $162 billion for Time Warner, but AOL's value plummeted in subsequent years and required a goodwill impairment charge of between $40 billion and $60 billion (the amount was heavily debated among the company and accountants). In previous years, this amount would have been amortized over time, but it must now be evaluated annually and written down if, as in the case of AOL, the value is no longer there.

Firms must account for amortization as stipulated in major accounting standards. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) both have similar definitions of what qualifies as an intangible asset, but there are differences in how their values must be adjusted over time.

For instance, development costs to create new products are expensed under GAAP (in most cases) but capitalized (amortized) under IFRS. GAAP does not also allow for revaluing the value of an intangible, but IFRS does. This means that GAAP changes in value can be accounted for through changing amortization schedules, or potentially writing down the value of an intangible, which would be considered permanent. Finally, GAAP stipulates that advertising expenditures be expenses as incurred, but IFRS does allow recognizing a prepayment of these expenses as an asset, which would be capitalized or amortized as they are used at a later date.

In its August 2013 10-K filing with the SEC, technology giant Intel (INTC) provided the following exhibit related to operating expenses:

It detailed that the amortization of intangibles was due in good part to its purchase of software security firm McAfee. You can also see that R&D is expensed annually, even though it results in value in terms of Intel’s new product sales and future profits. Intel provided the following discussion on how it accounts for its identified intangible assets:

"Licensed technology and patents are generally amortized on a straight-line basis over the periods of benefit. We amortize all acquisition-related intangible assets that are subject to amortization over their estimated useful life based on economic benefit. Acquisition-related in-process research and development assets represent the fair value of incomplete research and development projects that had not reached technological feasibility as of the date of acquisition; initially, these are classified as 'other intangible assets' that are not subject to amortization. Assets related to projects that have been completed are transferred from 'other intangible assets' to 'acquisition-related developed technology'; these are subject to amortization, while assets related to projects that have been abandoned are impaired and expensed to research and development. In the quarter following the period in which identified intangible assets become fully amortized, we remove the fully amortized balances from the gross asset and accumulated amortization amounts."

Amortization reflects the fact that intangible assets have value that must be monitored and adjusted over time. The amortization concept is subject to classifications and estimates that need to be studied closely by a firm’s accountants, and by auditors that must sign off on the financial statements.