Amortized average cost

What Is Amortized Average Cost?

Amortized Average Cost is not a widely recognized standalone financial accounting term but rather represents a conceptual combination of two distinct accounting principles: amortization and average cost. It broadly falls under the umbrella of Financial Accounting, focusing on how certain asset costs are systematically reduced over time.

Amortization is the process of expensing the cost of an Intangible Assets over its estimated Useful Life. Unlike tangible assets that undergo Depreciation, intangible assets, such as Patents, copyrights, and certain organizational costs, are amortized. This accounting treatment allows a business to allocate the initial Capital Expenditures of an intangible asset across the periods in which it contributes to revenue generation.

Average cost, on the other hand, is a method used primarily in Inventory Valuation or for determining the Cost Basis of investments. It involves calculating the average cost of all units available for sale or all shares purchased, and then applying this average to value remaining inventory or determine the cost of sold items. When considering "Amortized Average Cost," one might conceptually refer to the amortization of an asset whose initial cost was determined using an average cost methodology, or perhaps the average cost expensed per period during the amortization process.

History and Origin

The concept of amortization has historical roots in the need to systematically allocate the cost of assets that provide benefits over multiple accounting periods. While early accounting focused more on tangible assets and depreciation, the rise of intellectual property and other non-physical assets necessitated a similar systematic expensing method. The general principle of spreading costs over an asset's useful life has been a cornerstone of accrual accounting for centuries.

In modern financial reporting, standards bodies provide explicit guidance on amortization. For instance, the International Accounting Standards Board (IASB) outlines the accounting requirements for intangible assets under International Accounting Standard (IAS) 38, stating that intangible assets with a finite useful life must be amortized systematically over that life.¹⁰ Similarly, in the United States, the Financial Accounting Standards Board (FASB) provides guidance on intangible assets. A significant shift occurred in 2001 with FASB Statement No. 142, which generally ceased the amortization of Goodwill for public companies, instead requiring annual impairment testing.⁹ However, private companies were later given an option to amortize goodwill under a 2014 FASB Accounting Standards Update.

The average cost method for inventory gained prominence as a practical approach to valuing inventory, especially for businesses with high volumes of undifferentiated goods. It smooths out cost fluctuations, offering a more stable per-unit cost compared to methods like First-In, First-Out (FIFO) or Last-In, First-Out (LIFO). The application of "Amortized Average Cost" is not tied to a specific historical event or regulatory pronouncement, as it is a conceptual blend rather than a defined accounting standard.

Key Takeaways

• Amortized Average Cost is not a standard financial accounting term but combines the principles of amortization and average cost.
• Amortization systematically expenses the cost of an intangible asset over its useful life, such as patents or copyrights.
• The primary purpose of amortization is to match the expense of an intangible asset with the revenues it helps generate, reflecting its consumption over time.
• Average cost is an inventory or investment costing method that calculates a weighted average cost for units available, smoothing out price fluctuations.
• While amortization is a defined accounting practice for certain assets, the "average cost" component, when combined, primarily refers to the method by which the initial cost of an asset to be amortized might have been determined, or the average periodic expense resulting from amortization.

Formula and Calculation

Since "Amortized Average Cost" is a conceptual term rather than a specific accounting method with a dedicated formula, its calculation involves understanding the individual components.

The most common method for calculating amortization is the Straight-Line Method. This method allocates an equal amount of expense to each period over the asset's useful life.

The formula for straight-line amortization is:

Where:

• Cost of Intangible Asset is the initial capitalized cost of the asset.
• Useful Life is the estimated period over which the asset is expected to provide economic benefits.

For average cost in the context of inventory, the weighted average cost method is typically used. This involves dividing the total cost of goods available for sale by the total number of units available for sale.

The formula for weighted average cost per unit is:

If "Amortized Average Cost" were to be conceptualized as the average amortization expense per period over the asset's useful life, it would simply be the straight-line amortization expense itself. If it referred to amortizing an asset whose initial capitalized cost was determined using an average cost method (e.g., if a company acquired multiple similar intangible rights at varying prices and averaged their cost for accounting purposes), the Cost of Intangible Asset in the amortization formula would be that calculated average.

Interpreting the Amortized Average Cost

Interpreting "Amortized Average Cost" primarily requires understanding its constituent parts within the broader context of accounting. The concept emphasizes the systematic allocation of costs over time, which is fundamental to accurate financial reporting and analysis.

When an intangible asset's cost is amortized, the resulting amortization expense on the Income Statement reflects the portion of the asset's value consumed during that period. This helps users of Financial Statements understand the true profitability of a business, as the full initial cost of a long-lived asset is not expensed in the year of acquisition. The accumulated amortization reduces the book value of the intangible asset on the Balance Sheet, providing a clearer picture of its remaining economic value.

The "average cost" aspect, if applied to the initial determination of an intangible asset's cost, means that the capitalized amount represents a blended cost rather than the specific cost of a single, identifiable acquisition. This approach smooths out cost fluctuations for similar assets acquired at different times or prices. However, it is less common for unique intangible assets like a patent.

In essence, "Amortized Average Cost" highlights the spread of a potentially averaged initial cost over the asset's useful life. It aids in recognizing a consistent expense, contributing to smoother earnings over time, and offering insights into the average cost allocated per period for an asset that has its cost recovery spread out.

Hypothetical Example

Imagine a fictional tech company, "InnovateCo," which acquires three different software licenses over a short period, each granting similar operational rights for five years, but at slightly varying costs due to market conditions at the time of purchase:

• License A: $100,000
• License B: $110,000
• License C: $120,000

InnovateCo decides to treat these as a pool of similar Intangible Assets and uses an average cost approach to determine their collective capitalized value for amortization purposes.

First, calculate the average cost:
Total Cost = $100,000 + $110,000 + $120,000 = $330,000
Number of Licenses = 3
Average Cost per License = $330,000 / 3 = $110,000

Next, InnovateCo needs to amortize this "average cost" over the five-year Useful Life of the licenses using the Straight-Line Method.

Annual Amortization Expense = Average Cost per License / Useful Life
Annual Amortization Expense = $110,000 / 5 years = $22,000 per year per license.

If considering the entire pool of licenses, the total annual amortization would be $330,000 / 5 = $66,000. In this hypothetical scenario, the "Amortized Average Cost" refers to the $22,000 per year per license (or $66,000 for the total pool), which is the average portion of the initial average cost expensed annually. This example illustrates how an "average cost" might serve as the basis for subsequent amortization.

Practical Applications

The principles underlying "Amortized Average Cost"—namely amortization and average costing—have distinct practical applications in business and finance.

Amortization is crucial in several areas of accounting and taxation:

• Intangible Assets: Companies amortize the cost of acquired intangible assets like Patents, copyrights, trademarks (if they have a finite useful life), and software. This allows businesses to spread the expense of these valuable assets over the periods they benefit the company.
• ⁷, ⁸ Loan Payments: In the context of debt, amortization refers to the process of paying off a loan with regular payments, where each payment includes both principal and interest, with a greater proportion of principal paid over time.
• Startup and Organizational Costs: Businesses may amortize certain startup and organizational costs over a period, typically 180 months (15 years) for tax purposes in the U.S., as guided by the Internal Revenue Service (IRS). This is detailed in IRS Publication 535, "Business Expenses." Thi⁴, ⁵, ⁶s allows new businesses to deduct these initial expenses gradually rather than all at once.
• Bond Premiums/Discounts: The premium or discount on a bond is amortized over the life of the bond, adjusting the effective interest rate recognized.

Average cost methods are predominantly used for:

• Inventory Valuation: Companies often use the Weighted Average Cost method to value their inventory and calculate Cost of Goods Sold. This method is particularly suitable for businesses where inventory items are indistinguishable or flow through the system rapidly.
• Investment Cost Basis: Investors may use an average cost method to determine the Cost Basis of shares purchased at different prices, simplifying capital gains calculations, though specific identification methods are also common.

While "Amortized Average Cost" is not a standard application, its conceptual components help in accurately reflecting asset consumption and cost recovery, which are vital for a company's Financial Statements.

Limitations and Criticisms

As "Amortized Average Cost" is a conceptual blend rather than a defined accounting method, its limitations and criticisms stem from the individual principles of amortization and average costing, as well as the potential ambiguity of combining these terms.

Limitations and criticisms of amortization include:

• Subjectivity of Useful Life: Determining the Useful Life of an Intangible Assets can be highly subjective, especially for assets like patents or copyrights whose economic benefits might extend beyond their legal lives or become obsolete sooner than expected. This subjectivity can lead to inconsistencies in financial reporting.
• Goodwill Treatment: A significant point of contention has been the non-amortization of goodwill for public companies under U.S. GAAP, which instead requires annual impairment testing. Cri³tics argue that goodwill is a "wasting asset" that should be amortized, believing that impairment tests are insufficient to reflect its true decline in value. Pro²ponents of the impairment-only model, however, argue that goodwill does not have a determinable useful life and that amortization would not accurately reflect its value.
• ¹ Lack of Cash Flow Impact: Amortization is a non-cash expense, meaning it does not involve an outflow of cash. While it reduces reported net income, it does not directly impact a company's cash position, which can sometimes be misunderstood by stakeholders.

Limitations and criticisms of average cost methods include:

• Less Precise Cost Tracking: For businesses where specific identification of inventory items is feasible (e.g., high-value, unique items), average cost methods might not provide the most precise matching of specific costs with revenues.
• Doesn't Reflect Current Costs: In periods of fluctuating costs, the average cost method may not accurately reflect the most recent costs of inventory or investments, potentially leading to a less current valuation on the Balance Sheet.

The primary criticism of using the combined phrase "Amortized Average Cost" is its lack of a formal definition within financial accounting standards. While the underlying concepts are fundamental, combining them in this manner can lead to confusion or suggest a specific methodology that does not exist in standard practice. Clarity in terminology is paramount in financial reporting to ensure consistent understanding and comparability of financial data.

Amortized Average Cost vs. Amortized Cost

The distinction between "Amortized Average Cost" and "Amortized Cost" lies primarily in the "average" qualifier and its implication.

Amortized Cost is a widely recognized accounting concept, particularly prevalent in the valuation of financial assets and liabilities, as well as the broader process of Amortization of intangible assets. When referring to financial instruments, "amortized cost" is the initial measurement amount of the asset or liability minus principal repayments, plus or minus cumulative amortization of any difference between the initial amount and the maturity amount, and minus any reduction for impairment. In the context of intangible assets, "amortized cost" simply refers to the asset's original cost less its accumulated amortization. It represents the carrying value of the asset on the Balance Sheet after applying the amortization process.

Amortized Average Cost, as discussed, is not a standard term. If used, it conceptually suggests the amortization of an asset whose initial cost was determined by an average cost method (e.g., a Weighted Average Cost for a group of similar intangible assets). Alternatively, it might refer to the average expense recognized each period from the amortization process itself. The "average" component in "Amortized Average Cost" implies a prior calculation of the asset's basis using an averaging method, before the amortization process begins, or an emphasis on the per-period average. In contrast, "Amortized Cost" is a more general term for the carrying value of an asset or liability after amortization has been applied, without specific reference to how its original cost was determined. The confusion often arises because both terms involve the systematic reduction of an asset's or liability's value over time.

FAQs

What is the primary purpose of amortization?

The primary purpose of Amortization is to allocate the cost of an Intangible Assets over its Useful Life, matching the expense to the periods in which the asset helps generate revenue. This provides a more accurate representation of a company's profitability over time.

How is amortization different from depreciation?

Amortization applies to intangible assets, which lack physical substance (e.g., patents, copyrights). Depreciation applies to tangible assets, which have physical substance (e.g., buildings, machinery). Both are methods of expensing the cost of a long-lived asset over its useful life.

What does "average cost" typically refer to in accounting?

"Average cost" typically refers to methods used for Inventory Valuation, such as the Weighted Average Cost method. It calculates a blended average cost for all units of inventory available for sale, which is then used to determine the cost of goods sold and the value of ending inventory.

Is "Amortized Average Cost" a standard accounting term?

No, "Amortized Average Cost" is not a standard, formally defined term in Financial Accounting. It conceptually combines the principles of amortization and average costing. If encountered, it likely refers to the amortization of an asset whose original cost was determined using an average cost method, or the average expense recognized per period from the amortization.