Linda’s question:
Yes, this question occurred to today me as I was reviewing a tax return:
“Why is there amortization on patents and other intangible property sometimes, but not always? And what does that tell us about the business?”
Linda’s answer:
The basics of amortization
Amortization is the bookkeeping write-off of intangible items. These items do not have a physical component but have value like patents, intellectual property, trademarks, licenses, software, and customer lists. For example, if an insurance company buys another company, they are really purchasing their ‘book of business’- which is another name for the customer list.
Intangible assets must be something that can be measured reliably and for which there is a future economic benefit.
A customer list is not good forever. If we do not engage with the list, or if we do and find that not everyone is willing to become our customer, the value of that list diminishes with time. Amortization allows us to write it off over time, based on our guess as to the useful life of the list. These days, a customer list that has not engaged with a company after two years is likely stale, although it depends on the nature of the business and the list.
What does amortization on the tax return tell us?
This tells us there is an intangible asset with a dropping value. It is likely this asset was acquired by this company although it could be something they developed through R&D (research and development).
For me, the best indicator of what is going on is the balance sheet. If it is an 1120, 1120S, or 1065 a balance sheet is required. (Smaller companies are not.)
Go down the assets and find intangible assets.
- If the asset is listed but there is no accumulated amortization, the asset is not being amortized. This means it is an asset, like intellectual property, that is not declining in value and has an indefinite life. Even with those assets, the company is required to consider if the value is impaired and write it down if the future benefits have dropped below the original cost.
- If the asset is listed and the accumulated amortization is not as high as the asset, either the value of that asset has not fully declined or there is a mix of assets, some declined and some that do not decline in value.
- If the asset is listed and the accumulated amortization is equal to the asset amount, the asset is fully declined based on the accounting estimate. It may also just disappear from the balance sheet due to write-offs.
Why do we care?
As those of you who have attended our training on tax return analysis (click here to access online training), we focus on more than just number-crunching and filling out worksheets to understand the borrower and their operations if they are a business. Going beyond the rule to add back amortization, and understanding what it means when you see it on the balance sheet, can help you understand the business.
For example, in our own company, Lenders Online Training LLC, our records show the asset ‘Intellectual Property’ because the company bought the intellectual property we use to develop our online modules, manuals, and other resources from the creator of those assets. Since the value of those assets is not declining, you will not see amortization expense nor will you see accumulated amortization on our balance sheet.
If over several years you see the Intellectual Property amount drop, then perhaps it is dropping in value. That would be true if the modules were never updated as tax laws change, for example. Of course, we keep our intellectual property current.
More info for you
Our modules on global cashflow analysis of tax returns will give you the big picture and help you drill down to recurring cashflow. Each of these modules are 30-minute-or-less.
The training includes
- modules on individual forms and schedules in the 1040, 1065, 1120 and 1120s
- weekly virtual classes for overall topics
- mid-term and final case studies with assistance and review by our senior credit trainers in break-out rooms with no more than three people
- two 200+ page manuals for reference long after the class is done
