Chapter 1.7® - Partial Year Amortization (Nearest Whole Month), Half-Year Amortization Rule, Revising Amortization Rates
Partial Year Amortization
When a capital asset is purchased say on the 18th of March, this is partially through the month. When an asset is purchased (or disposed of) at a time other than the beginning or end of an accounting period, amortization expense is calculated for a part of that year. This is essential because due to the matching principle, we have to record an expense for the portion of the year that the capital asset generated revenues. For partial year amortization, there are 2 methods:
a) Nearest Whole Month Amortization
When calculating amortization for partial years
to the nearest whole month, amortization for the month is calculated as
if the asset was in use for more than ½ of the month. For instance,
consider the high end machine used in our previous examples was bought
on March 18th, 2009. The purchase price is $15,000 and it has a predicted
useful life of 5 years, through to March 18th, 2014. It has a salvage
value of $3000.
However, if the asset had been purchased on March 12th, 2009, then we would not include the month of March in our calculation (therefore 9 out of 12 months). Here’s the calculation for this scenario:
In terms of disposing off an asset, the same scenario would apply. For instance, imagine the high end computer was disposed off on May 19th, 2009. How would we record amortization expense for the year, assuming the asset is amortized annually on December 31st. Here’s the calculation:
Notice we multiply by 5/12 because we include the month of May 2009 since the asset was disposed off past the half month (May 15th).
b) Half-Year Rule Amortization
For large organizations that have thousands of different capital assets on their Balance sheet, tracking individual purchase date of each asset and then calculating amortization to the nearest month would become quite a costly process. Because this kind of detail or accuracy would not necessarily increase the usefulness of the income statement, the materiality principle allows us to use a more cost-effective method in these circumstances; this is known as the half-year amortization rule. Using the half-year rule, it doesn’t matter what time of the year the asset was purchased on or disposed off, we will still record 6 months (half year) worth of amortization expense.
For instance, consider the high end machine used in our previous examples was bought on March 18th, 2009. The purchase price is $15,000 and it has a predicted useful life of 5 years, through to March 18th, 2014. It has a salvage value of $3000.
Revising Amortization Rates
Original amortization is
based on the original purchase cost of an asset, estimated salvage value
and useful life. However, if the cost of the asset changes due to an improvement
or if the useful life is adjusted, a revised amortization schedule for
current and future periods must be calculated.
If the estimated salvage value or useful life of a capital asset changes, we use the new estimate to calculate revised amortization for current and future periods. This does not mean we have to go back to all the years we have already amortized for, that is left unchanged. However, we revise the amortization expense calculation by spreading the cost that has not yet been amortized over the remaining useful life. For instance, consider the following example:
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.
Imagine on December 31st, 2005, the estimated remaining useful life changes from 3 years to 4 years, and the Salvage value is revised from $3000 to $1200. Here’s how our new amortization calculation would look like:
Revising estimated salvage value or useful life of an asset is known as a “change in accounting estimate” and results from exercise of judgement, reappraisal & occurrence of new events (as additional or new information about the asset is obtained). A change in accounting estimate is always given a prospective treatment, meaning it is reflected in current & future financial statements, and prior financial statements are unchanged.