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Amortization and depreciation

Comparing depreciation and amortization. Created by Sal Khan.

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Video transcript

You'll often hear the words depreciation and amortization used together. And what I want to do in this video is to understand a little bit better why they are similar and the slight difference between the two. So in our previous examples, we've done depreciation. And so you could imagine in period zero we buy a truck for $60,000. And instead of just expensing it in period zero, instead of putting $60,000 expense right over here, we capitalize it. We say that we have a $60,000 asset. And so this is right at the end of period zero or at the beginning of period one. And what we do is we spread out this expense over the period of time that we're actually going to use the truck. So in period one, we depreciate the truck by $20,000. We're assuming we have a three year life of this truck. And we're just going to do what's called straight line depreciation. We're just going to take the cost of the truck and divide it by its life. There's other ways to depreciate it. Maybe you could imagine that it depreciates faster in the first year, but this is the simplest type. And it's actually used by a lot of companies, just straight line depreciation. So after we use $20,000, we depreciate the truck by $20,000. We expense it in that year. So this is literally an expense. Then at the end of period one, it is now on our books for $40,000. Then in period two, we depreciate it by another $20,000. It is going to be an expense, a $20,000 expense in period two. Now on our books at the end of period two, it'll be worth 20. Then in period three, we expense another $20,000 on our income statement. And then on, at least for just this truck, assuming we haven't bought a new one yet, we've completely written it off. It is now worth zero on our books because based on what we assumed, it's not useful anymore. We kind of have to scrap this truck. That's depreciation. Now imagine if to run our trucking business we also have to pay some type of license fee. So let me call this a license fee. And let's say that the license fee was $4,000. And we get to use it over four years. So once again, you could have just put a $4,000 expense right over here, but that's not really accurate. You're not just using the fee in that period. That fee is going to be useful over the next four years. So once again, you would put down the asset, the paid license fee or maybe the prepaid license fee depending on how you view it. And then you would amortize that cost, which is essentially the same thing mathematically. You'd say, look, I'm going to use this over the next four years, essentially $1,000 a year. So my license fee amortization in year one I'd say is $1,000. And then on my books I would carry the license fee for $3,000. Then I'd amortize another $1,000. Then it would go down to $2,000. Amortize another $1,000. Then at the end of period three, it's now worth $1,000 on my books. Period four, amortize another $1,000. Now I've completely written it off and I probably have to get another license at this point. So mathematically, they're the same thing. Even philosophically, they're the same thing. The idea that instead of expensing these expenses all at once you're saying, look, they have some useful life. Let me spread out the expense over their useful life. The difference between the two-- and you might have already kind of realized this-- is depreciation is when you have hard assets. If you have a building or a truck or some type of equipment, you would depreciate that asset. If you have a non-hard asset or a financial asset or something that's less tangible, then you would just amortize it. This is just kind of a different word depending on how tangible the asset is. So if it's a license fee or some other type of fee or some type of it maybe intellectual property, you would amortize the cost. If you have a truck or a building or whatever, you would depreciate it.