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Current time:0:00Total duration:3:49

Video transcript

in the last video we had this situation where we have to buy a truck every three years because that's how long they last and we were at first just expensing the truck so it's sixty thousand dollars every three years but it did something very strange to our operating profit it made it look like the years that we bought the truck that our business didn't do well and then the other years it did really well even though this was a really consistent business so what we hinted at at the last video is maybe we can do something called capitalizing the expense we could capitalize the truck so what we do is instead of just saying that the truck is an expense we say that we're buying an asset that has some useful life beyond the time that we're just expensing it so what we do is let's just put a balance sheet right here at the beginning of year one so the beginning of year one this is our balance sheet balance sheet right over here and we're by capitalizing a truck we are essentially saying we're going to spend $60,000 let's say we started with $60,000 in cash we use that $60,000 in cash to buy a truck so on our balance sheet we now have only one asset called a truck let me do it this way so in the asset category we have a truck and we are saying that right when it's brand new it is worth $60,000 and we have no liabilities so I'll just put a zero there and so our equity our shareholders equity is 60,000 minus 0 which is 60,000 our company is worth $60,000 on our books and the way that we account for this truck that lasts three years is we say well look this has a useful life of three years essentially let's just spread that $60,000 out over the three years or another way to say it let's say that this truck is costing us $20,000 a year $20,000 a year or another way we can say that is that we can depreciate the value of the truck and that depreciation is an expense so depreciation of truck so instead of just calling a truck I'll call it the truck depreciation and you could just really view this as a way of spreading out the cost of the truck so in the first year we're going to depreciate our truck by twenty thousand we're going to say that it's one third one third of its value has been served or it's now twenty thousand dollars worth less at the end of the year than it was at the beginning in the second year twenty thousand in the third year twenty thousand so we just really spread out the sixty thousand over the life of the truck and what that does is is it makes our operating profit consistent which it should be because we have a very consistent business one hundred minus 50 minus twenty we make 30 and year one thirty and year two thirty and year three and then we just keep going these all become 20s and so because we have such a consistent business we make thirty thousand dollars the whole way through now what does depreciation do to our balance sheet so at the beginning of year one we had a truck that was worth sixty thousand dollars if you forward to the end of year one or the beginning of year two what's going to happen is because we're depreciating the value of the truck on our balance sheet we took a twenty thousand dollar depreciation expense on our balance sheet the value of the truck over the course of the year will go from sixty thousand to forty thousand to forty thousand and then at the end of year two if we go another year forward the value that we keep the trucks on the books for will go down to twenty thousand and then at the end of year three it's going to go down to zero and then we go buy another truck so we'll go back to sixty thousand will keep going but the cool thing about this is it makes the expense very consistent and actually more consistent with what our business is actually doing