How to Calculate Straight Line Amortization

Amortization is an accounting process used to methodically write down the cost of an intangible asset over its useful life. Intangible assets are non-physical items of value a company owns, such as patents, copyrights, or customer lists. This process allows a business to allocate the cost of the asset as an expense, matching the expense with the revenues the asset helps to generate.

The straight-line method is the most common approach for this calculation. It involves spreading the cost of the intangible asset evenly across each accounting period of its useful life. This results in the same amount of amortization expense being recorded in the financial statements each year, providing a simple and consistent way to account for the asset’s diminishing value.

Information Needed for Calculation

To calculate amortization, you need the asset’s initial cost. This represents the full purchase price or acquisition cost, which includes all expenditures necessary to get the asset ready for its intended use.

Next, the asset’s useful life must be determined. This is the estimated period over which the asset is expected to contribute to a company’s revenue and cash flows. The useful life can be influenced by legal or contractual limits, such as a patent’s 20-year legal term. For tax purposes, Section 197 of the Internal Revenue Code often requires a 15-year useful life for certain intangibles.

Finally, the salvage value of the asset needs to be estimated. Salvage value is the expected residual worth of an asset at the end of its useful life. For most intangible assets, the salvage value is assumed to be zero. A non-zero salvage value can only be used if there is a commitment from a third party to purchase the asset at the end of its life or if an active market for the asset is expected to exist.

Calculating the Amortization Expense

The calculation of the annual amortization expense using the straight-line method is direct. The formula requires subtracting the asset’s salvage value from its initial cost and then dividing that amount by the estimated useful life. The formula is: (Initial Cost – Salvage Value) / Useful Life.

To illustrate, consider a company that acquires a patent for a total cost of $100,000. Management determines that the patent has an estimated useful life of 10 years, and the salvage value is estimated to be $0.

Using these figures, the annual amortization expense can be calculated. The initial cost of $100,000 minus the salvage value of $0 is divided by the 10-year useful life. The result is an annual amortization expense of $10,000, which will be recorded each year for the next decade.

Creating an Amortization Schedule

An amortization schedule is a table that outlines the allocation of an intangible asset’s cost over its useful life. This schedule provides a clear, period-by-period breakdown of the amortization expense, the accumulated amortization, and the asset’s remaining book value.

Using the previous example of a patent with a $100,000 cost and a 10-year life, a schedule would show the progression annually. In Year 1, the beginning book value is $100,000. The amortization expense for the year is $10,000, and the accumulated amortization at year-end is also $10,000, resulting in an ending book value of $90,000.

In Year 2, the beginning book value is $90,000, and another $10,000 of amortization expense is recorded. This brings the accumulated amortization to $20,000 and reduces the ending book value to $80,000. This process continues until the end of Year 10, at which point the book value of the patent will be zero.

Accounting for Amortization

Recording amortization requires a specific journal entry in the company’s accounting records. To recognize the expense, the Amortization Expense account is debited, and a contra-asset account called Accumulated Amortization is credited. A contra-asset account is paired with an asset account to reduce its overall value on the balance sheet.

This journal entry has a direct impact on a company’s financial statements. The debit to Amortization Expense increases the company’s operating expenses on the income statement, which in turn reduces its net income and taxable income. For tax reporting, businesses use Form 4562, Depreciation and Amortization, to claim this deduction.

On the balance sheet, the credit to Accumulated Amortization increases the balance of this contra-asset account. The Accumulated Amortization is then subtracted from the initial cost of the intangible asset to report the asset’s net book value.