Yes, today this question is one that occurred to 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?
The basics on amortization
Amortization is the bookkeeping write-off of intangible items. These are items that do not have a physical component but have value like patents, intellectual property, trademark, license, software and customer lists. For example, if an insurance company buys another company, what they really are buying is the ‘book of business’, 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.
But a customer list is not good forever. If we do not engage with the list, or even if we do but not everyone is willing to become our customer, the value of the 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 me 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 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 that is required to include the balance sheet. (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-off.
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 if a business, the operation. 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, Lenders Online Training LLC shows the asset ‘Intellectual Property’ because the company bought the intellectual property behind the 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 the 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 law changes, for example. Of course, that is not happening.
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