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Chapter 1.4® - Methods of Amortizing Capital Assets - Straight Line Amortization, Units of Production & Double-Declining balance (Accelerated Amortization method)

Methods of Amortization

There are 3 ways of amortizing Capital assets over their useful lives. We shall describe each one in depth below.

 i) Straight-line amortization ii) Units of production iii) Double-declining balance (accelerated method)

i) Straight Line Amortization

Straight-line amortization expenses the same amount to expense each period over the useful life of the capital asset. There is a 2 step process used to calculate the amortization expense:

 a) First calculate the amortization cost by subtracting the asset’s salvage or residual value from its total cost. b) Secondly, divide this difference by # of years this asset will be useful.

The simple formula is summarized as:

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

Consider BB Company purchased a high-end computer on January 1st, 2004 for \$15,000 and used it throughout its predicted useful life of 5 years, through to December 31st, 2008. The salvage value is expected to be \$3,000.

 Amortization Expense = (\$15,000 - \$3,000) / 5 years = \$2400/year

Here is the accounting entry to be made at the end of December 31st, 2004, after using the computer for 1 year.

 December 31st, 2004 Account Name Debit Credit Dr. Amortization Expense \$2,400 Cr. Accumulated Amortization \$2,400 Entry to record single-line amortization of of \$2,400 per year for a 5 year useful life.

The debit to Amortization expense appears on the Income Statement in the Operating expenses section. The Credit to Accumulated Amortization appears below the Computer Equipment Asset account as a Contra-asset account. Remember through Accumulated Amortization, we are keeping track of the reduction in value of the Computer Asset control account. This is why accumulated amortization is a contra-asset account. Here’s how these entries are reflected on the Balance sheet.

 Computer Equipment \$15,000 Less: Accumulated Amortization (\$2,400) BOOK VALUE \$12,600

In order to save space on the balance sheet, many organizations list the Computer Equipment asset net of accumulated amortization. This means the accumulated amortization has already been subtracted from the asset account, here’s how it looks.

 Computer Equipment (net) \$12,600

 Year Cost to Amortize Amortization Rate Amortization Expense Accumulated Amortization Net Book Value \$15,000 2004 \$12,000 * 20% ** \$2,400 \$2,400 \$12,600 2005 \$12,000 20% \$2,400 \$4,800 \$10,200 2006 \$12,000 20% \$2,400 \$7,200 \$7,800 2007 \$12,000 20% \$2,400 \$9,600 \$5,400 2008 \$12,000 20% \$2,400 \$12,000 \$3,000 ***

 * Cost to be Amortized = \$15,000 - \$3000 (Salvage Value) = \$12,000 ** Amortization Rate = 100% / # of Years to be Amortized = 100% / 5 = 20% *** Note the \$3,000 is the ending Book Value of the asset on December 31st, 2008. Note also that this number is NOT \$0. Why? This is because we do not amortize an asset below its salvage value.

From the schedule, we note that:

 i) Amortization expense is \$2,400 throughout all the 5 years. ii) Accumulated Amortization is the sum of prior period’s amortization + current period amortization expense. iii) The book value goes down every year and equals the salvage value at the end of the asset’s useful life.

This chart shows the linear amortization expense of \$2,400 per year that the company incurs; this amortization expense is recorded on the Income statement as a non-cash expense.

This chart shows the decline in book value (recorded value) of the capital asset declining at a pace of \$2,400 per year on a linear basis. Note the graph shows that the ending book value of the asset will be \$3,000 in 2008 and beyond upon which it is disposed.