Amortization

Amortization

• The process of allocating cost to expense over the useful (service) life of an asset

•Provides proper matching of expenses with revenues

•A process of cost allocation, it does not determine market value.

•It does not accumulate cash for replacement of the asset

Calculating amortization

To calculate amortization, one must

determine:

1. The cost of the asset

Costs to acquire asset and make it ready for use

2. Its estimated useful (productive) life

• Can be expressed in terms of time, units of activity or units of output

• Based on assessment of use, obsolescence and other relevant factors

3. The estimated residual value

• Estimated value of asset at end of its useful life

Amortization methods

Three alternative methods:

1. Straight-line

2. Declining-balance

3. Units-of-activity

B. Each method is acceptable under generally accepted accounting principles(GAAP)

C. Management selects the method that best measures an asset’s contribution to revenue

D. Once chosen, it should be applied consistently

Stright line method

(cost - residual value)/estimated useful life

Amortization expense ( stright line)

is constant every year of asset’s useful life

Amortizable cost/estimated useful life

• Amortizable cost:

the amount to be amortized

cost - residual value

Declining balance method

• Amortization expense based on asset’s declining net book value

• Cost less accumulated amortization

• Amortization rate remains constant, but net book value declines each year

(Net book value at the beginning of the year) x (stright line rate x 2) = annual amortization expense

Units of activity method

• Useful life expressed as total units of production or activity

• Must estimate the total units of activity that will be obtained from asset

amortizable cost/total estimated units of activity = amortizable cost per unit

amortizable cost per unit x units of activity during the year = annual amortizable expense

the cost of a asset

Costs to acquire asset and make it ready for use

The estimated useful life

• Can be expressed in terms of time, units of

activity or units of output

• Based on assessment of use,

obsolescence and other relevant factors

estimated residual value

• Estimated value of asset at end of its useful life

annual amortization expense (declining)

net book value at the beginning of the year * stright line rate x 2

amortizable cost per unit

amortizable cost/ total estimate of unti activity

annual amortization expense (unit of actvity)

amortizable cost per unti x unit of activity during the year