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Chapter 1.3® - Amortization of Capital Assets – Process of Cost Allocation & Calculating Amortization Expense, Salvage Value & Useful Life

All capital assets wear out or decline in usefulness and value as they become aged and are used, thus an amortization expense must be recorded. Accounting amortization is the process of allocating or matching the cost of capital assets over the time that they are used. Cost of capital assets should be amortized over their useful lives by one of the 3 prescribed accounting amortization methods described below.

As an example, assume a delivery van was bought for \$25,000 on January 1st, 2008. It is estimated that the van will help generate revenue and be used in business operations for 4 years, bringing in revenue of \$40,000 a year. At the end of 4 years, its salvage value will be nil meaning the Van will be useless. Accountants could treat this transaction and record a \$25,000 expense in the year the van was purchased, 2008. However, net income would be distorted because we will not have matched the expense of the delivery van over the 4 years that it is creating revenue. This below table explains the scenario that is not in compliance with Generally Accepted Accounting Principles (GAAP).

 Year 2008 2009 2010 2011 Revenue \$40,000 \$40,000 \$40,000 \$40,000 Expenses (\$25,000) \$0 \$0 \$0 Net Income/Loss \$15,000 \$40,000 \$40,000 \$40,000

Instead of following the above schedule, we could apply the matching principle of GAAP and allocate the cost of the delivery van over the periods it generates revenue. Here’s the schedule below:

 Year 2008 2009 2010 2011 Revenue \$40,000 \$40,000 \$40,000 \$40,000 Expenses (\$6,250)*** (\$6,250) (\$6,250) (\$6,250) Net Income/Loss \$33,750 \$33,750 \$33,750 \$33,750

** \$25,000 / 4 years = \$6,250 per year

This \$6,250 allocation of expense over 4 years is known as accounting amortization expense. Here are a couple of important things to realize about amortization expense:

 i) Amortization is a process of cost allocation, not asset valuation. It does not measure the decline in the van’s relative market value each period; it merely recognizes the expense of using the van. ii) Amortization also does not measure the physical deterioration of the van.

Calculating Amortization Expense

There are 3 factors used in determining amortization expense. They are

 i) Cost of Asset ii) Salvage or Useful Life iii) Useful life

a) Cost of Capital Asset

The cost of a capital asset is all necessary and reasonable expenses incurred to prepare the asset for its intended purpose or use. See the above chapter on “Cost of Capital assets” for complete information.

b) Salvage Value

Salvage value is also known as residual or scrap value. Salvage value is the estimated amount of money the corporation expects to receive from selling or disposing off the asset at the end of its useful life. Other companies also prefer trading off their asset for a quicker transaction. The amortization expense is calculated as:

 Amortization Expense = (Total Cost of Capital Asset – Salvage Value) / # of Useful Years

c) Useful Life

The useful life of a Capital asset is the estimated # of years the asset is expected to be used in business operations of the company. Also known as ‘service life’, useful life is not necessarily the asset’s total productive life. For example, the total estimated life of a brand new computer is 3 – 4 years, yet many large organizations prefer to trade in their old computers for new ones every 2 years. In this regard, the computers would have a useful life of 2 years.

Predicting the useful life of an asset is a hard thing to do because of several reasons. These include wear and tear from normal business operations, obsolescence and inadequacy. When an organization is growing fast, its assets become obsolete faster, as the company needs new improved technology or hardware to keep growing. Thus, inadequacy refers to the condition where the capacity of the company’s capital assets is not strong enough to meet the needs of its operations. Obsolescence refers to when due to sophisticated new technological advancements and improvements, the company’s current capital assets become obsolete and need to be replaced. The company usually disposes off the obsolete asset before it reaches its full useful life.

Since predicting useful life of a new asset is very difficult, most organizations use past experience or if no past experience is available, the company uses other scientific or engineering research from a well known author or organization.