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
Amortizable Cost per Unit:
[ \frac{(Cost - Residual Value)}{Number of Units of Estimated Productive Life} = \frac{(10,000 - 1,000)}{5,000} = 1.80 ]
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
Original Useful Life: 5 years
Salvage Value: 10,000
Accumulated Amortization: $9,000
Three Cases for Sale:
Book Value Sale:
Sold at $1,000.
Above Book Value Sale:
Sold at $2,000; record gain.
Below Book Value Sale:
Sold at $500; record loss.
Disposal of Fixed Assets - Accounting Entries
Case 1: Sale at Book Value ($1,000)
Journal Entry:
Debit: Bank 𝑆1000
Credit: Accumulated Amortization 𝑆9,000
Credit: Equipment 𝑆10,000
Case 2: Sale Above Book Value ($2,000)
Journal Entry:
Debit: Bank 𝑆2,000
Credit: Equipment 𝑆10,000
Credit: Gain on Disposal 𝑆1,000
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.