Accumulated amortization is a figure that represents the use of an intangible asset. Intangible assets have specific useful lives and include items like patents, copyrights, contract rights, in addition to similar items not felt or seen. Companies do not expense these items immediately after purchase. Accountants post an amortization expense each month to represent the use of the intangible asset. Accumulated amortization is a contra asset that reduces the overall asset dollar amount on the company’s balance sheet.
Companies can record the acquisition cost and related expenses to acquire an intangible item as an asset. Assets increase a company’s value. By recording the item as an asset, the company increases its net income for the period and also increases its assets on the balance sheet. As the company uses the item, it records amortization and accumulated amortization to represent the monthly and annual use of the intangible asset. Companies can group intangible assets by type, such as patents and copyrights.
Accountants determine amortization by dividing an intangible asset's total acquisition cost by its years of useful life. Most years of useful life are dictated by a country’s laws; in most cases, the years of useful life can be greater than 20 or 30 years. The basic division allows companies to report a straight-line amount for amortization purposes. For example, a patent worth $50,000 US Dollars (USD) with a useful life of 20 years has an annual amortization expense of $2,500 USD.
A basic journal entry is necessary to record amortization and accumulated amortization. Accountants debit amortization expense and credit accumulated amortization. The debit reduces the current period’s profit as reported on the income statement. The credit goes to the accumulated amortization contra asset account on the balance sheet. A contra asset account has a negative balance yet resides in the asset section of the balance sheet.
Business stakeholders can determine the value of a company’s intangible asset by netting together the asset and contra asset account. Using the previous example, the company has a patent worth $50,000 USD on its balance sheet. After six years, accountants will have recorded $15,000 USD in accumulated amortization, a credit balance. Netting these amounts together represents a patent value of $35,000 USD. Stakeholders can do this for each intangible asset on the company’s balance sheet.
Amortization is very similar to depreciation. Depreciation, however, is for physical assets such as property plants and equipment. Recording depreciation works in the same manner as amortization, although physical assets can have different useful lives and depreciation calculations.