How are Intangible Assets Accounted For
Accounting for intangible assets can be a complex process due to their non-physical nature and the varying ways they can be acquired or developed. Here’s a general outline of how intangible assets are typically accounted for under U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS):
- Initial Recognition and Measurement: When an intangible asset is purchased from another party, it is usually recognized at its acquisition cost. This includes the purchase price and any directly attributable costs of preparing the asset for its intended use (like legal fees for a patent). If an intangible asset is developed internally, whether it can be capitalized (i.e., recognized as an asset on the balance sheet) or needs to be expensed can depend on various factors, including the stage of development and the degree of certainty that future economic benefits will flow to the entity.
- Subsequent Measurement : After initial recognition, intangible assets are typically carried at their cost less any accumulated amortization and any accumulated impairment losses.
- Amortization: Unlike tangible assets, which are depreciated, intangible assets are amortized over their useful lives. This involves expensing a portion of the asset’s cost each accounting period. If an intangible asset has a finite useful life, it is amortized over that useful life. However, if the useful life is indefinite (like a brand name or goodwill), the asset is not amortized but must be tested for impairment at least annually.
- Impairment: Impairment testing is performed to determine whether the carrying amount of an intangible asset exceeds its recoverable amount (the higher of the asset’s fair value less costs of disposal and its value in use). If the carrying amount exceeds the recoverable amount, an impairment loss is recognized. This loss reduces the carrying amount of the intangible asset on the balance sheet and is also recognized as an expense on the income statement.
These are general guidelines, and specific practices can vary based on the type of intangible asset and the accounting standards being used. Also, estimating the useful life or the future economic benefits of an intangible asset often involves a degree of judgement, which can add to the complexity of accounting for these assets.
Example of How Intangible Assets are Accounted For
Let’s use an example of a tech company purchasing a patent to illustrate how intangible assets are accounted for.
- Initial Recognition and Measurement: Let’s say TechCompany A purchases a patent from TechCompany B for $2 million. The patent is expected to be useful in TechCompany A’s operations for the next 10 years. The purchase price of $2 million is the initial cost of the patent and is the amount at which the patent is initially recognized on TechCompany A’s balance sheet.
- Subsequent Measurement : The patent will be carried on TechCompany A’s balance sheet at its cost less any accumulated amortization and any impairment losses.
- Amortization: The patent has a finite useful life of 10 years. TechCompany A will therefore amortize the cost of the patent over its useful life. If the company uses straight-line amortization, it will recognize an amortization expense of $200,000 each year for 10 years ($2 million / 10 years).At the end of the first year, for example, the patent’s net book value on the balance sheet would be $1.8 million ($2 million original cost – $200,000 in accumulated amortization).
- Impairment: At the end of each accounting period, or more frequently if there are indicators of impairment, TechCompany A will test the patent for impairment. Suppose at the end of year 3, due to technological advancements, the company determines that the future economic benefits from the patent are less than initially expected.If TechCompany A determines that the patent’s recoverable amount is now only $1.2 million, then it would recognize an impairment loss of $200,000 ($1.4 million carrying amount – $1.2 million recoverable amount). This impairment loss reduces the carrying amount of the patent on the balance sheet to its recoverable amount of $1.2 million, and is also recognized as an expense on the income statement.
This example simplifies the process but gives a general idea of how intangible assets are accounted for. The actual accounting can be more complex and depends on the specific circumstances and the accounting standards being used.