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Amortization

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					                                              Amortization


Amortization is the allocation of the cost of a capital asset to expense over its useful (service) life in
a rational and systematic manner.

Cost allocation is designed to provide for the proper matching of expenses with revenues in
accordance with the matching principle.

Amortization is a process of cost allocation, not a process of asset valuation.

The net book value (cost less accumulated amortization) of a capital asset may differ significantly
from its fair market value.

Accumulated amortization represents the total cost of a capital asset that has been charged to
expense; it is not a cash fund.

A decline in revenue producing ability may occur because of:

      Physical factors such as wear and tear.

      Economic factors such as obsolescence, which is the process of becoming out of date before
       the asset physically wears out.

Amortization Methods

The calculation of amortization expense is based on three factors:

      Cost

      Useful life (service life) is an estimate of the expected productive life of the asset. Useful life
       may be expressed in terms of time, units of activity, or in units of output.

      Residual value (salvage value) is an estimate of the asset’s value at the end of its useful life.

There are three common methods of amortization: straight-line, declining-balance, and units-of-
activity.

Under the straight-line method, amortization is the same for each year of the asset’s useful life.
The formula for calculating annual amortization expense is amortizable cost (cost less residual value)
divided by useful life. The straight-line method is simple to apply, and it matches expenses with
revenues appropriately when the use of the asset is reasonably uniform throughout service life.

             If an asset is acquired part-way through the year, the amortization is prorated for the
              time the asset was in use during the year.

The declining-balance method produces a decreasing annual amortization expense over the useful
life of the asset. Annual amortization expense is calculated y multiplying the net book value at the
beginning of the year by the constant straight-line amortization rate. This rate is often increased by a
declining-balance multiplier (e.g., 1, 1 ½, 2, 3). The method is compatible with the matching principle
in that the higher amortization expense in early years is matched with the higher benefits received in
these years.
             If an asset is acquired part-way through the year, the amortization is prorated for the
              time the asset was in use during the year.

Under the units-of-activity method, instead of expressing the life as a time period, useful life is
expressed in terms of the total units of production or use expected from the asset. Annual
amortization expense is calculated by multiplying amortization cost per unit by the units of activity
during the year. This method is not nearly as popular as the straight-line method because it is often
difficult to make a reasonable estimate of total activity.

             If an asset is acquired part-way through the year, the amortization is unaffected, since
              the units of activity already reflect the time the asset was in use during the year.

Amortization and Income Tax

Canada Customs and Revenue Agency (CCRA) allows the taxpayer to deduct amortization expense
when calculating taxable income.

For income tax purposes, taxpayer must use the single declining-balance method, applied to a group
of like assets. CCRA specifies the rates that must be used for each class of assets. There are
certain other rules (e.g., ½ year rule) and restrictions that must be followed when applying this
method, termed capital cost allowance (CCA)


Revising Periodic Amortization

If physical or economic factors indicate that annual amortization is inadequate or excessive, a change
should be made.

Revisions of periodic amortization are considered to be changes in estimates and are made in current
and future years but not retroactively.

To determine the new annual amortization expense, the asset’s amortizable cost at the time of the
revision (net book value less residual value) is divided by its remaining useful life.


Task on Hand:

Questions 7 – 11 page 493
Brief exercises 5-8 page 494
Exercise 3-6 page 496
Problems
2A page 499
3A page 499
4A page 499