Unit 2_ Activity 5 - Amortization

Unit Overview

  • Activity 5: Amortization

Overview of Amortization

  • Businesses require capital assets to create revenue.

  • Costs of assets are matched to the revenue they generate.

  • Assets typically depreciate in value over time.

  • This unit explores amortization and methods of calculation.

  • Disposal of assets is also covered.

Purpose of Amortization

Main Reasons

  • Cost Allocation: Distributes asset costs over years of generating revenue.

  • Physical Factors: Assets may wear out, reducing revenue potential.

  • Economic Factors: Assets may become obsolete before physical wear (e.g., fax machines).

  • Land Exception: Land is not amortized; often increases in value due to scarcity.

  • Amortization doesn't create funds for asset replacement; it reallocates asset cost from the balance sheet to the income statement annually.

Recording Amortization

  • Recorded as an adjusting entry at the end of a fiscal period before financial statements are prepared.

  • Journal Entry:

    • Debit: Amortization Expense

    • Credit: Accumulated Amortization

  • Each depreciable asset has a contra-asset account (Accumulated Amortization) that reflects book value.

Amortization Methods

Choosing an Amortization Method

  • According to GAAP, firms must choose a method that best matches depreciation costs to revenue.

  • Consistency principle: same method used each fiscal period.

Straight-Line Method

  • Assumes even asset contribution to revenue over its life.

  • Example Calculation:

    • Cost: $10,000

    • Salvage Value: $1,000

    • Useful Life: 5 years

    • Formula: [ Amortization Expense = \frac{(Cost - Salvage Value)}{Estimated Useful Life} ]

    • Computation: [ Amortization Expense = \frac{(10,000 - 1,000)}{5} = 1,800 ]

  • Same amortization expense annually for 5 years.

Units of Activity Method

  • Suitable when wear and tear dictates depreciation, with varying asset usage.

  • Useful life measured in units (kilometers, miles, hours).

  • Example Calculation for a machine:

    • Cost: $10,000

    • Salvage Value: $1,000

    • Total Estimated Productive Life: 5,000 units

    • Current Period Usage: 750 units

Calculation Steps

  1. Amortizable Cost per Unit:

    • [ \frac{(Cost - Residual Value)}{Number of Units of Estimated Productive Life} = \frac{(10,000 - 1,000)}{5,000} = 1.80 ]

  2. Amortization Expense:

    • [ Amortization Expense = Amortizable Cost per Unit \times Number of Units Produced ]

    • [ Amortization Expense = 1.80 \times 750 = 1,350 ]

Declining Balance Method

  • Assumes greater revenue contribution early in life (accelerated amortization method).

  • Rate Calculation:

    • Single Declining Balance Rate = [ \frac{1}{# of years of useful life} ]

    • Example: [ 1/5 = 20% ]

    • Double Declining Balance Rate = 20% x 2 = 40%

  • Amortization Formula:

    • [ Amortization Expense = Book Value \times Declining Balance Rate ]

  • Example for $10,000 machine:

    • Year 1: [ 10,000 \times 0.4 = 4,000 ]

CRA and Tax Considerations

  • For tax net income calculations, businesses must adhere to rates set by the Canada Revenue Agency (CRA) (Capital Cost Allowance).

Revising Estimates

Adjustment Scenario

  • Example asset:

    • Cost: $10,000

    • Original Useful Life: 5 years

    • Salvage Value: $1,000

    • Annual Amortization:

      • [ \frac{(10,000-1,000)}{5} = 1,800/year ]

  • After 2 years: New useful life re-evaluated at 10 years.

New Amortization Rate Calculation

  • Remaining Book Value:

    • After 2 years: [ 10,000 - 3,600 ]

    • New Calculation: [ \frac{(6,400 - 1,000)}{8} = 675/year ]

Disposing of Fixed Assets

  • Upon selling, abandoning, or exchanging:

    • Remove both asset and accumulated accounts from the balance sheet.

  • Example:

    • Machine Cost: $10,000

    • Accumulated Amortization: $9,000

  • Three Cases for Sale:

    1. Book Value Sale:

    • Sold at $1,000.

    1. Above Book Value Sale:

    • Sold at $2,000; record gain.

    1. Below Book Value Sale:

    • Sold at $500; record loss.

Disposal of Fixed Assets - Accounting Entries

  1. Case 1: Sale at Book Value ($1,000)

    • Journal Entry:

      • Debit: Bank 𝑆1000

      • Credit: Accumulated Amortization 𝑆9,000

      • Credit: Equipment 𝑆10,000

  2. Case 2: Sale Above Book Value ($2,000)

    • Journal Entry:

      • Debit: Bank 𝑆2,000

      • Credit: Equipment 𝑆10,000

      • Credit: Gain on Disposal 𝑆1,000

  3. Case 3: Sale Below Book Value ($500)

    • Journal Entry:

      • Debit: Bank 𝑆500

      • Credit: Equipment 𝑆10,000

      • Debit: Loss on Disposal 𝑆500

Trade-In Allowances

  • Assets may be traded in for discounts on new purchases.

  • Fair market value is essential for calculations due to potential price discrepancies between actual value and dealer offers.

  • Example:

    • Old machine cost: $10,000

    • Accumulated amortization: $9,000

    • New machine list price: $25,000

    • Trade-in allowance: $1,000; fair market: $500.

Journal Entry for Trade-In

  • Cash Paid Calculation:

    • Cash Paid = List Price - Trade-In

    • Cash Paid = 25,000 - 1,000 = 24,000

    • Cost of New Asset:

    • Cost of New Asset = Cash Paid + Fair Market Value

    • Cost of New Asset = 24,000 + 500 = 24,500

  • Journal Entry Adjustments included for gain or loss on disposal.