What Is the Amortization of Intangibles?

Amortization of intangibles, also simply known as amortization, is the process of expensing the cost of an intangible asset over the projected life of the asset for tax or accounting purposes. Intangible assets, such as patents and trademarks, are amortized into an expense account called amortization. Tangible assets are instead written off through depreciation. The amortization process for corporate accounting purposes may differ from the amount of amortization used for tax purposes.

Understanding the Amortization of Intangibles

For tax purposes, the cost basis of an intangible asset is amortized over a specific number of years, regardless of the actual useful life of the asset (as most intangibles don’t have a set useful life). The Internal Revenue Service (IRS) allows intangibles to be amortized over a 15-year period if it’s one of the ones included in Section 197.

Intangible assets are non-physical assets that can be assigned an economic value. Intellectual property (IP) is considered to be an intangible asset and is a broad term that encompasses most intangible assets. Most IP is covered under Section 197. Examples of these Section 197 intangible assets include patents, goodwill, trademarks, and trade and franchise names.

Not all IP is amortized over the 15-year period set by the IRS, however. There are certain exclusions, such as software acquired in a transaction that is readily available for purchase by the general public, subject to a nonexclusive license, and has not been substantially modified. In those cases and select others, the intangibles are amortized under Section 167.

Special Considerations

When a parent company purchases a subsidiary company and pays more than the fair market value (FMV) of the subsidiary’s net assets, the amount over fair market value is posted to goodwill (an intangible asset). IP is initially posted as an asset on the firm’s balance sheet when it is purchased.

IP can also be internally generated by a company’s own research and development (R&D) efforts. For instance, a company may win a patent for a newly developed process, which has some value. That value, in turn, increases the value of the company and so must be recorded appropriately.

In either case, the process of amortization allows the company to write off annually a part of the value of that intangible asset according to a defined schedule.

Amortization vs. Depreciation

Assets are used by businesses to generate revenue and produce income. Over a period of time, the costs related to the assets are moved into an expense account as the useful life of the asset dwindles. By expensing the cost of the asset over a period of time, the company is complying with GAAP, which requires the matching of revenue with the expense incurred to generate the revenue.

Tangible assets are expensed using depreciation, and intangible assets are expensed through amortization. Depreciation generally includes a salvage value for the physical asset—the value that the asset can be sold for at the end of its useful life. Amortization doesn’t take into account a salvage value.

Types of Amortization

For accounting (financial statement) purposes, a company can choose from six amortization methods: straight line, declining balance, annuity, bullet, balloon, and negative amortization. There are only four depreciation methods that can be used for accounting purposes: straight line, declining balance, sum-of-the-years’ digits, and units of production.

For tax purposes, there are two options for amortization of intangibles that the IRS allows. These are straight line and the income forecast method. The income forecast method can be used instead of the straight-line method if the asset is: motion picture films, videotapes, sound recordings, copyrights, books, or patents. For depreciation of physical assets, the IRS only allows the Modified Accelerated Cost Recovery System (MACRS).

Example of Amortization

Assume, for example, that a construction company buys a $32,000 truck to contractor work, and that the truck has a useful life of eight years. The annual depreciation expense on a straight-line basis is the $32,000 cost basis minus the expected salvage value—in this case, $4,000—divided by eight years. The annual deprecation for the truck would be $3,500 per year, or ($32,000 – $4,000) ÷ 8.

On the other hand, assume that a corporation pays $300,000 for a patent that allows the firm exclusive rights over the intellectual property for 30 years. The firm’s accounting department posts a $10,000 amortization expense each year for 30 years.

Both the truck and the patent are used to generate revenue and profit over a particular number of years. Since the truck is a physical asset, depreciation is used, and since the rights are intangible, amortization is used.

What Is Accounting Conservatism?

Accounting conservatism is a set of bookkeeping guidelines that call for a high degree of verification before a company can make a legal claim to any profit. The general concept is to factor in the worst-case scenario of a firm’s financial future. Uncertain liabilities are to be recognized as soon as they are discovered. In contrast, revenues can only be recorded when they are assured of being received.

How Accounting Conservatism Works

Generally Accepted Accounting Principles (GAAP) insist on a number of accounting conventions being followed to ensure that companies report their financials as accurately as possible. One of these principles, conservatism, requires accountants to show caution, opting for solutions that reflect least favorably on a company’s bottom line in situations of uncertainty.

Accounting conservatism is not intended to manipulate the dollar amount or timing of reporting financial figures. It is a method of accounting that provides guidance when uncertainty and the need for estimation arise: cases where the accountant has the potential for bias.

Accounting conservatism establishes the rules when deciding between two financial reporting alternatives. If an accountant has two solutions to choose from when facing an accounting challenge, the one that yields inferior numbers should be selected.

A cautious approach presents the company in a worst-case scenario. Assets and revenue are intentionally reported at figures potentially understated. Liabilities and expenses, on the other hand, are overstated. If there is uncertainty about incurring a loss, accountants are encouraged to record it and amplify its potential impact. In contrast, if there is a possibility of a gain coming the company’s way, they are advised to ignore it until it actually occurs.

Recording Revenue

Accounting conservatism is most stringent in relation to revenue reporting. It requires that revenues are reported in the same period as related expenses were incurred. All information in a transaction must be realizable to be recorded. If a transaction does not result in the exchange of cash or claims to an asset, no revenue may be recognized. The dollar amount must be known to be reported.

Advantages of Accounting Conservatism

Understating gains and overstating losses means that accounting conservatism will always report lower net income and lower financial future benefits. Painting a bleaker picture of a company’s financials actually comes with several benefits.

Most obviously, it encourages management to exercise greater care in its decisions. It also means there is more scope for positive surprises, rather than disappointing upsets, which are big drivers of share prices. Like all standardized methodologies, these rules should also make it easier for investors to compare financial results across different industries and time periods.

Disadvantages of Accounting Conservatism

On the flip side, GAAP rules such as accounting conservatism can often be open to interpretation. That means that some companies will always find ways to manipulate them to their advantage.

Another issue with accounting conservatism is the potential for revenue shifting. If a transaction does not meet the requirements to be reported, it must be reported in the following period. This will result in the current period being understated and future periods to be overstated, making it difficult for an organization to track business operations internally. 

Using Accounting Conservatism

Accounting conservatism may be applied to inventory valuation. When determining the reporting value for inventory, conservatism dictates the lower of historical cost or replacement cost is the monetary value.

Estimations such as uncollectable account receivables (AR) and casualty losses also use this principle. If a company expects to win a litigation claim, it cannot report the gain until it meets all revenue recognition principles.

However, if a litigation claim is expected to be lost, an estimated economic impact is required in the notes to the financial statements. Contingent liabilities such as royalty payments or unearned revenue are to be disclosed, too.

What Is an Appropriation?

Appropriation is when money is set aside for a specific purpose. A company or a government appropriates funds in order to delegate cash for the necessities of its operations. Appropriations for the U.S. federal government are decided by Congress through various committees. A company might appropriate money for short-term or long-term needs that include employee salaries, research and development, and dividends.

What Does an Appropriation Tell You?

Appropriations tell us how money or capital is being allocated whether it’s through the federal government’s budget or a company’s use of cash and capital. Appropriations by governments are made for federal funds each year for various programs. Appropriations for companies may also be known as capital allocation.

Appropriation could also refer to setting apart land or buildings for public use such as for public buildings or parks. Appropriation can also refer to when the government claims private property through eminent domain.

Federal Appropriations

In the United States, appropriations bills for the federal government’s spending are passed by U.S. Congress. The government’s fiscal year runs from October 1 through September 30 of each calendar year.

Each fiscal year, the U.S. President submits a budget proposal to Congress. Budget committees in the U.S. House and Senate, then determine how the discretionary portion of the budget will be spent through a budget resolution process. The process yields an allocation of an amount of money that is assigned to the various appropriations committees. The House and Senate appropriations committees divide the money up between the various subcommittees that represent the departments that’ll receive the money. Some of the departments include the following:

• Department of Agriculture
• Department of Defense
• Department of Energy
• Department of Commerce
• Department of Labor
• Department of Transportation

Federal programs such as Social Security and Medicare fall under the mandatory expenditures category and receive funding through an automatic formula rather than through the appropriations process.

Congress also passes supplemental appropriations bills for instances when special funding is needed for natural disasters and other emergencies. For example, in December 2014, Congress approved the Consolidated and Further Continuing Appropriations Act, 2015. The act approved $5.2 billion to fight the Ebola virus in West Africa and for domestic emergency responses to the disease. The act also allocated funding for controlling the virus and developing treatments for the disease.

Appropriations in Business

Corporate appropriations refer to how a company allocates its funds and can include share buybacks, dividends, paying down debt, and purchases of fixed assets. Fixed assets are property, plant, and equipment. In short, how a company allocates capital spending is important to investors and the long-term growth prospects of the company.

How a company appropriates money or invests its cash is monitored closely by market participants. Investors watch to determine whether a company is using its cash effectively to build shareholder value or whether the company is engaged in frivolous use of its cash, which can lead to the destruction of shareholder value.

Monitoring Corporate Appropriations

Investors monitor corporate appropriations of cash by analyzing a company’s cash flow statement. The cash flow statement (CFS) measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses. The cash flow of a company is divided into three activities or behavior:

1. Operating activities on the cash flow statement include any sources and uses of cash from business activities such as cash generated from a company’s products or services.
2. Investing activities include any sources and uses of cash from a company’s investments such as a purchase or sale of an asset.
3. Cash from financing activities includes the sources of cash from investors or banks, as well as the uses of cash paid to shareholders. The payment of dividends, the payments for stock repurchases, and the repayment of debt principal (loans) are included in this category.

Example of Company Appropriations

Below is the cash flow statement for Exxon Mobil Corporation (XOM) from Sept 30, 2018, as reported in its 10Q filing. The cash flow statement shows how the executive management of Exxon appropriated the company’s cash and profits:

• Under the investing activities section (highlighted in red), $13.48 billion was allocated to purchase fixed assets or property, plant, and equipment.
• Under the financing activities section (highlighted in green), cash was allocated to pay down short-term debt in the amount of $4.279 billion.
• Also under financing activities, dividends were paid to shareholders (highlighted in blue), which totaled $10.296 billion.

Whether Exxon’s use of cash is effective or not is up to investors and analysts to debate since evaluating the process of appropriating cash is highly subjective. Some investors might want more money allocated to dividends while other investors might want Exxon to allocate money towards investing in the future of the company by purchasing and upgrading equipment.

Appropriations vs. Appropriated Retained Earnings

Appropriated retained earnings are retained earnings (RE) that are specified by the board of directors for a particular use. Retained earnings are the amount of profit left over after a company has paid out dividends. Retained earnings accumulate over time similar to a savings account whereby the funds are used at a later date.

Appropriated retained earnings can be used for many purposes, including acquisitions, debt reduction, stock buybacks, and R&D. There may be more than one appropriated retained earnings accounts simultaneously. Typically, appropriated retained earnings are used only to indicate to outsiders the intention of management to use the funds for some purpose. Appropriation is the use of cash by a company showing how money is allocated and appropriated retained earnings outlines the specific use of that cash by the board of directors.

Limitations of an Appropriation

For investors, the cash flow statement reflects a company’s financial health since typically the more cash that’s available for business operations, the better. However, there are limitations to analyzing how money is spent. An investor won’t know if the purchase of a fixed asset, for example, is a good decision until the company begins to generate revenue from the asset.

As a result, the investor can only infer whether the management is effectively deploying or appropriating its funds properly. Sometimes a negative cash flow results from a company’s growth strategy in the form of expanding its operations.

By studying how a company allocates its spending and uses its cash, an investor can get a clear picture of how much cash a company generates and gain a solid understanding of the financial well being of a company.

What Is at Par?

The term “at par” means at face value. A bond, preferred stock, or other debt instrument may trade at par, below par, or above par.

Par value is static, unlike market value, which fluctuates with credit ratings, time to maturity, and interest rate fluctuations. The par value is assigned at the time the security is issued. When securities were issued in paper form, the par value was printed on the face of the security, hence the term “face value.”

Understanding at Par

Due to the constant fluctuations of interest rates, bonds and other financial instruments almost never trade exactly at par. A bond will not trade at par if current interest rates are above or below the bond’s coupon rate, which is the interest rate that it yields.

A bond that was trading at par would be quoted at 100, meaning that it traded at 100% of its par value. A quote of 99 would mean that it is trading at 99% of its face value.

Par value for common stock exists in an anachronistic form. In its charter, the company promises not to sell its stock at lower than par value. The shares are then issued with a par value of one penny. This has no effect on the stock’s actual value in the markets.

A New Bond

If, when a company issues a new bond, it receives the face value of the security, the bond is said to have been issued at par. If the issuer receives less than the face value for the security, it is issued at a discount. If the issuer receives more than the face value for the security, it is issued at a premium.

The yield for bonds and the dividend rate for preferred stocks have a material effect on whether new issues of these securities are issued at par, at a discount, or at a premium.

A bond that trades at par has a yield equal to its coupon. Investors expect a return equal to the coupon for the risk of lending to the bond issuer.

Example of at Par

If a company issues a bond with a 5% coupon, but prevailing yields for similar bonds are 10%, investors will pay less than par for the bond to compensate for the difference in rates. The bond’s value at its maturity plus its yield up to that time must be at least 10% to attract a buyer.

If prevailing yields are lower, say 3%, an investor is willing to pay more than par for that 5% bond. The investor will receive the coupon but have to pay more for it due to the lower prevailing yields.