Amortization

In the depreciation video, we saw that if a company had to buy some equipment for its factory, let's say at the beginning of 2007, just based on the cash that went out of the door, there might have been this temptation to say, OK, in 2007, we had an equipment expense. EQ expense. And they could have just wrote, let's say that equipment cost $50,000. So they would have just put a $50,000 expense right in 2007. I write it as a negative number just because I like to remember it's an expense, although normally people just write it as a positive expense, but I always like to put a negative for an expense to know that it's going to subtract from your revenue. So they would put that cash expense there in 2007. And then in future years, maybe 2008, 2009, 2010, they would have no expense until maybe they had to replace that machine or buy a new one. And we saw that that is one way to account for things, but it really doesn't reflect the reality of the business. The fact that this machine right here that cost $50,000 is used for-- in this example, in the depreciation video, it was usable for two years. Let's say in this example, it's usable for four years. So what they do is, instead of just expensing the cost of the machine, when the machine is bought on the balance sheet at the beginning of 2007, they say, we now have an asset called a machine. I'll just call it M for machine. That's $50,000 at this point right here, right when we bought the machine. Remember, balance sheets are snapshots in time. And then instead of having an equipment expense, instead of having that expense, they'll have an equipment depreciation expense. And the difference here is instead of saying that the entire expense was that machine in just the first period, they're saying no, we're using some of the machine in that period. And let's say we do a straight-line depreciation, which means we essentially depreciate the asset evenly over its lifespan. So in this case, we're assuming it's a four-year lifespan. So let me draw that out. So the asset should linearly go to zero over these four years. So essentially, in the first year, our expense would be what? It's $12,000. If you divide $50,000 by 4, it's $12,500. It would be minus $12,500 in each year, depreciation expense, and we would account for it on the balance sheet. Because remember, income statements are just telling you how do you get from one balance sheet to another. So expenses reduce the value of your assets. So, for example, in this one, at the beginning of the period, before the 2007 income statement, the asset was worth $50,000. We depreciated $12,500 from it, so at this point in time, the balance sheet as of the end of 2007 or the beginning of 2008, we're going to say that our machine is now $12,500 less, so $47,500. And then at the end of 2008, beginning of 2009, our balance sheet under the assets, the machine, if they gave us that level of granularity, would be $12,500 less than that. So that's what? $37,500. So then the machine is $25,000. And then another $12,500 on the books. It'll say the machine is worth $12,500. And then at the end of 2010, it'll say the machine is worth nothing. And if we did our depreciation schedule right, or if the lifespan of this machine really is four years, then it's time to go buy another machine and start doing this all over again. This is all a review of the depreciation video. Amortization is the exact same thing, but it deals with intangible assets. What's an intangible? It's something you can't see, touch, feel, smell, eat. Obviously , a machine you can't do all of those things to it, but you can at least touch it and possibly smell and taste it. So an intangible asset, we can't do any of that stuff to, but it's the exact same idea. For example, let's say we are some type of widget company. And let me write down the years: 2007, 2008, 2009 and 2010. And let's say that if we just did it from a cash point of view, let's say we had to buy a patent in order to make our widgets. So we could have said, oh, we have to buy a patent expense. We had to buy a patent from some brilliant inventor someplace. We could just say, oh, you know what? The patent cost $4,000. So we could just put that there even though the useful life of the patent might be four years. And so it doesn't reflect the fact that we still are using that patent in these years, and we just take the hit here. So this income will look unusually low, while these will look unusually high. It's not reflective of the fact that you're using this patent that has four years left on it. So instead of doing that, what you do is, at the beginning of the period you say, we have acquired a patent, an asset, that is worth $4,000, And then every year over the life of the patent, we'd amortize a fourth of it since it has a four-year life. So it would be patent amortization. And there's all sorts of intangible assets that you might amortize. And amortizing really just means spreading out the cost of this asset, just like depreciation was spreading out the cost of a physical asset. So patent amortization would be $1,000 in this year, $1,000 in this year, $1,000 in this year, and $1,000 in this year. And then our snapshot, or our balance sheet at the end of 2007, will have on its assets a patent that's now worth $3,000. And at the end of 2008, it'll have a patent that's now worth $2,000. The end of 2009-- I think you get the point-- you'll have a patent worth $1,000. And at the end of 2010, probably because the patent is now expired and anyone can go out and produce whatever that invention that was patented without having the patent, we then say that the patent is worthless. And a very relevant thing is if you were a drug company and you were buying the patent to some pharmaceutical that had four years left so that you could have exclusive rights to develop that drug. and at this point, all of a sudden, now anyone can develop the drug, so that patent is worthless. So the balance sheet is really trying to capture what your asset is worth at that point in time. At this point in time, your patent is arguably only worth $1,000, because you paid $4,000 for four years, and now you only have a year left. But that's all amortization is. Nothing fancy. Really, in my mind, it's very similar to depreciation. Depreciation is tangible. Amortization is intangible. It could be patents, it could be licenses. It could be fees associated with the financing. Let's say you have some debt that you took from a company, and the debt is going to last for 10 years, and you had to pay a one-time lump-sum to the bank. Well, that one-time lump-sum fee should probably be spread over the life of the debt, so you would amortize that expense over its life. Anyway, see you in the next video.