Amortization Introduction to amortization
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- 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.
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