03 Sep Straight Line Amortization
What is Straight Line Amortization?
Definition: Straight line amortization is a method of allocating interest or charging a cost at a consistent rate over a period. The principle of straight line amortization is used for:
- The allocation of interest on a bond issued by a company.
- The calculation of the monthly installments that are made to repay a loan.
- Charging off the cost of an intangible asset.
What does straight line amortization mean?
Let us review how the principle of straight line amortization applies in the three situations mentioned above.
- The allocation of interest on a bond issued by a company
If a company issues a bond at a discount, it needs to pay interest on the bond’s face value and not on the amount that it receives. To illustrate the point, consider a situation where a company issues a $1,000 bond at $950. The face value is $1,000 and the issue price is $950. The bond has been issued a discount of $50 or 5% of its face value. <br> </br>
The company will need to pay interest on the face value of $1,000, and not on the discounted issue price. It will also need to amortize the bond discount amount. By using the straight line amortization method, the company will write off the bond discount in equal amounts over the life of the bond. If the bond issue discussed here were a 5-year bond, the discount of $50 would have been written off at the rate of $10 every year for five years by using the straight line amortization method.
- The calculation of the monthly installments that are made to repay a loan
Straight line amortization refers to the repayment of a loan by making equal installment payments. While the sum that is paid every month is equal, the principal and interest components within the repayment amount vary. In the initial months, interest forms a larger part of the installment amount. As the loan repayment progresses, the installment amount includes a lower proportion of interest and an increasing principal repayment component.
- Charging off the cost of an intangible asset
An intangible asset like goodwill or intellectual property could be charged off using the principle of straight line amortization. Using this method, the intangible asset would be charged off over its useful life in equal yearly amounts.
Example of Straight Line Amortization
A company buys a patent for $50,000. It estimates its useful life to be five years. At the end of this period, the patent would not have any value. </br> </br>
Using the straight line amortization method, it charges the sum of $50,000 off at the rate of $10,000 a year over a period of five years.
Straight line amortization is a useful accounting principle as it allows expenses or interest to be calculated quickly and in a manner that is simple to understand.