Depreciation

Depreciation, a fundamental concept in accounting, illustrates the distribution of the cost of tangible and intangible assets over their useful life. People often use amortization to discuss losses for assets such as patents, trademarks, and goodwill. This guide will detail how to depreciate intangible assets. It will do so by providing clear explanations and real-life examples of this important subject.

 

Understanding Intangible Assets 

Intangible assets are those that a business can’t see or touch but that still make money. Some common examples are: 

  • Patents: Legal rights granted for inventions. 
  • Trademarks: These are distinctive signs, designs, or expressions that distinguish products or services. 
  • Goodwill: This includes the value attributed to a company’s brand name, customer relationships, and other intangible assets. 
  • Franchise Rights: These are rights granted to operate a business using a company’s brand and business model. 
  • Copyrights: Legal rights to creative works such as literature, music, and art. 

 

Legal Framework in India 

The Institute of Chartered Accountants of India (ICAI) issues the Accounting Standards (AS), which govern the accounting treatment of intangible assets in India and converge with the International Financial Reporting Standards (IFRS). Key standards include: 

  • AS 26: Intangible Assets 
  • Ind AS 38: Intangible Assets 

These standards explain how to recognize, measure, and amortize intangible assets over time. 

 

Recognition and Measurement

Initial Recognition: Intangible assets are recognized if: 

  • They are identifiable. 
  • The company controls the assets. 
  • It is likely that the company will make money in the future.  
  • It is possible to accurately estimate how much the asset costs.

Initial Measurement 

Initially, intangible assets are measured at cost. This includes the purchase price, any direct expenses incurred in preparing the asset for its intended use, and any associated legal and registration fees. 

 

Amortization of Intangible Assets

Useful Life 

The useful life of an intangible asset is defined as the period during which the company anticipates it will contribute to its cash flow. This duration can be either finite or indefinite. We employ amortization for intangibles with a finite life span.  

 

Amortization Method 

Amortization should reflect how an asset uses up its economic benefits. Some common ways are: 

  • Straight-Line Method: A constant amount is amortized each year. 
  • Reducing Balance Method: Amortization decreases over time. 

Example: A company invests INR 5,000,000 to secure a patent valid for 10 years. If you use the straight-line method, the cost of amortization would be INR 50,000 each year. 

 

Revaluation Model 

According to Ind AS 38, companies have the option to adopt the revaluation model for intangible assets post-initial recognition. This model allows companies to record assets at a revalued amount, considering any subsequent amortization and impairment losses. Despite reflecting fair value, the complexities associated with fair value measurement make this approach less frequently utilized. 

 

Impairment of Intangible Assets 

If intangible assets have an indefinite useful life or show signs of impairment, they must undergo an annual impairment test. An impairment occurs when an asset’s carrying amount exceeds its recoverable amount, necessitating a write-down. 

Example: A company owns a trademark worth INR 3,00,000. Due to market changes, the recoverable amount has fallen to INR 2,00,000. We must recognize an impairment loss of INR 1,00,000. 

 

Disclosure Requirements 

In their financial statements, companies are required to disclose information about intangible assets, including: 

  • The amortization methods used. 
  • The useful lives or amortization rates. 
  • Calculate the gross carrying amount and accumulated amortization. 
  • It is necessary to reconcile the carrying amount at the beginning and end of each period. 

 

Key Considerations

Estimating Useful Life: Determining the useful life of an intangible asset requires judgment and consideration of factors such as 

  • The assets are expected to be used. 
  • Obsolescence can be of a technical, technological, commercial, or other nature. 
  • The asset may have legal or comparable restrictions on its use. 

 

Amortization Consistency: You should review the amortization method and useful life at least at the end of each financial year. We should account for changes in estimates prospectively. 

Indefinite Useful Life: We do not apply amortization to assets with an indefinite useful life, such as certain trademarks or goodwill. We instead test these assets for impairment annually. 

Tax Implications: Under Indian tax laws, the Income Tax Act, 1961, allows for the depreciation of intangible assets. The rates and methods may differ from those used for accounting purposes. For example, the Income Tax Act prescribes a depreciation rate of 25% on a written-down value (WDV) basis for certain intangible assets. 

 

Questions to Test Your Understanding
  • Which of the following is an example of an intangible asset?
  1. Machinery 
  2. Building 
  3. Patent 
  4. Inventory 

 

  • According to Ind AS 38, which method can companies adopt for revaluing intangible assets post-initial recognition?
  1. Cost Model 
  2. Fair Value Model 
  3. Revaluation Model 
  4. Depreciation Model 

 

  • What is the initial measurement basis for intangible assets?
  1. Fair Value 
  2. Historical Cost 
  3. Market Value 
  4. Residual Value 

 

  • Under Indian tax laws, what is the prescribed depreciation rate for certain intangible assets on a written-down value (WDV) basis?
  1. 10% 
  2. 15% 
  3. 25% 
  4. 30% 

 

  • Which amortization method involves a constant amount being amortized each year?
  1. Reducing Balance Method 
  2. Straight-Line Method 
  3. Sum-of-Years’ Digits Method 
  4. Unit of Production Method 

 

Summary 

The depreciation of intangible assets plays a pivotal role in financial reporting, mirroring the gradual consumption of these assets’ economic benefits. India adheres to detailed standards governing this process, ensuring a methodical and reasoned allocation of costs. By comprehending and implementing these principles, businesses can precisely portray the value of their intangible assets, guaranteeing compliance and offering transparent insights into their financial standing. 

In summary, whether managing patents, trademarks, or goodwill, the correct recognition, measurement, and amortization of intangible assets remain imperative for precise financial statements. 

FAQ's

Intangible assets are non-physical assets that provide economic benefits to a business, such as patents, trademarks, copyrights, goodwill, and franchise rights.

We initially value intangible assets at cost, which includes the purchase price and any directly related expenses incurred to prepare the asset for its intended use.

Amortization refers to the systematic allocation of the cost of an intangible asset over its useful life.

The useful life of an intangible asset is defined by the duration over which it is anticipated to yield economic benefits for the company. This period can either be finite or indefinite.

Amortization refers to the allocation of the cost of intangible assets over their useful lives, while depreciation refers to the allocation of the cost of tangible fixed assets over their useful lives.

The company must recognize an impairment loss and write down an intangible asset to its recoverable amount if it carrying amount exceeds its recoverable amount.

Companies must disclose the amortization methods used, the useful lives or amortization rates, the gross carrying amount, accumulated amortization, and a reconciliation of the carrying amount at the beginning and end of each period.

Under the revaluation model, companies can carry intangible assets at a revalued amount, reflecting fair value at the date of revaluation, less any subsequent amortization and impairment losses. This approach requires periodic revaluations to ensure the carrying amount does not materially differ from the fair value.