Amortization/Depreciation
AMORTIZATION
Amortization is the process of allocating the cost of certain capital assets to expense over their useful life in a rational and systematic manner.
Amortization attempts to match the cost of a long-term, capital asset to the revenue it generates each period.
Amortization is an estimate rather than a factual measurement of the cost that has expired.
In recording amortization, Amortization Expense is debited and a contra asset account, Accumulated Amortization, is credited.
The difference between the cost of the asset and its related accumulated amortization is referred to as the net book value of the asset.
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AMORTIZATION
Balance Sheet Presentation
Office equipment $5,000
Less: Accumulated amortization 83
Net book value $4,917
Methodology
Straight-line depreciation
Straight-line depreciation is the simplest and most often used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life), and will expense a portion of original cost in equal increments over that period. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero. Salvage value is scrap value, by another name.
Straight-Line Method:
For example, a vehicle that depreciates over 5 years, is purchased at a cost of $17,000, and will have a salvage value of $2000, will depreciate at $3,000 per year: ($17,000 - $2,000)/ 5 years = $3,000 annual straight-line depreciation expense. In other words, it is the depreciable cost of the asset divided by the number of years of its useful life.
This table illustrates the straight-line method of depreciation. Book value at the beginning of the first year of depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated depreciation.
Book Value = Original Cost - Accumulated Depreciation
Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals scrap value.
| Book Value - Beginning of Year |
Depreciation Expense |
Accumulated Depreciation |
Book Value - End of Year |
|---|---|---|---|
| $17,000 (Original Cost) | $3,000 | $3,000 | $14,000 |
| $14,000 | $3,000 | $6,000 | $11,000 |
| $11,000 | $3,000 | $9,000 | $8,000 |
| $8,000 | $3,000 | $12,000 | $5,000 |
| $5,000 | $3,000 | $15,000 | $2,000 (Scrap Value) |
If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess would be considered a gain and subject to the depreciation recapture rule. In addition, this gain above the depreciated value would be recognized as ordinary income by the tax office. If the sales price is ever less than the book value, the resulting capital loss is tax deductible. If the sale price were ever more than the original book value, then the gain above the original book value is recognized as a capital gain.
If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.
[edit] Declining-Balance Method
Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decreasing charges in subsequent years are called accelerated depreciation methods. This may be a more realistic reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are new. One popular accelerated method is the declining-balance method. Under this method the Book Value is multiplied by a fixed rate.
Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year
The most common rate used is double the straight-line rate. For this reason, this technique is referred to as the double-declining-balance method. To illustrate, suppose a business has an asset with $1,000 Original Cost, $100 Salvage Value, and 5 years useful life. First, calculate straight-line depreciation rate. Since the asset has 5 years useful life, the straight-line depreciation rate equals (100% / 5) 20% per year. With double-declining-balance method, as the name suggests, double that rate, or 40% depreciation rate is used.
The table below illustrates the double-declining-balance method of depreciation. Book Value at the beginning of the first year of depreciation is the Original Cost of the asset. At any time Book Value equals Original Cost minus Accumulated Depreciation.
Book Value = Original Cost - Accumulated Depreciation
Book Value at the end of year becomes Book Value at the beginning of next year. The asset is depreciated until the Book Value equals Salvage Value, or Scrap Value.
| Book Value - Beginning of Year |
Depreciation Rate |
Depreciation Expense |
Accumulated Depreciation |
Book Value - End of Year |
|---|---|---|---|---|
| $1,000 (Original Cost) | 40% | $400 | $400 | $600 |
| $600 | 40% | $240 | $640 | $360 |
| $360 | 40% | $144 | $784 | $216 |
| $216 | 40% | $86.40 | $870.40 | $129.60 |
| $129.60 | $129.60 - $100 | $29.60 | $900 | $100 (Scrap Value) |
The Salvage Value is not considered in determining the annual depreciation, but the Book Value of the asset being depreciated is never brought below its Salvage Value, regardless of the method used. The process continues until the Salvage Value, or the end of the asset's useful life, is reached. In the last year of depreciation a subtraction might be needed in order to prevent Book Value from falling below estimated Scrap Value.
Since declining-balance depreciation doesn't always depreciate an asset fully by its end of life, some methods also compute a straight-line depreciation each year, and apply the greater of the two. This has the effect of converting from declining-balance depreciation to straight-line depreciation at a midpoint in the asset's life.
Capital Cost Allowance Method
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