If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

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

Video transcript

Voiceover: In the last video, we had this situation where we have to buy a truck every 3 years, because that's how long they last, and we were, at first, just expensing the truck. It's $60,000 every 3 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 the other years, it did really well, even though this was a really consistent business. What we hinted at in the last video is, maybe we can do something called "capitalizing" the expense. We could capitalize the truck. What we do is, instead of just saying that the truck is an expense, we can say that we're buying an asset, that has some useful life beyond the time that we're just expensing it. What we do is, let's just put a balance sheet right here, at the beginning of year 1. At the beginning of year 1, this is our balance sheet. Balance sheet, right over here. By capitalizing a truck, we're essentially saying we're going to spend $60,000. Let's say we start 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 1 asset, called "a truck." Let me do it this way. 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 0 there, and so our equity, our shareholders' equity, 60,000 - 0, which is 60,000. Our company is worth $60,000 on our books. The way that we account for this truck, that lasts 3 years, is we say, "Look, this has a useful life of 3 years." Essentially, "Let's just spread that $60,000 out, "over the 3 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 the depreciation is an expense. So, "depreciation of truck." Instead of just calling it truck, I'll call it the truck depreciation. You could just really view this as a way of spreading out the cost of the truck. In the first year, we're going to depreciate our truck by 20,000. We're going to say that it's 1 third ... 1 third of its value has been served, or it's now $20,000 worth less at the end of the year, than it was at the beginning. In the second year, 20,000. In the third year, 20,000. We just really spread out the 60,000 over the life of the truck. What that does is, it makes our operating profit consistent, which it should be, because we have a very consistent business. 100 - 50 - 20. We make 30 in year 1, 30 in year 2, 30 in year 3, and then we just keep going. These all become 20s, and so, because we have such a consistent business, we make $30,000 the whole way through. What does depreciation do to our balance sheet? At the beginning of year 1, we had a truck that was worth $60,000. If you forward to the end of year 1, or the beginning of year 2, what's going to happen is, because we're depreciating the value of the truck, on our balance sheet we took $20,000 depreciation expense, on our balance sheet the value of the truck over the course of the year will go from 60,000 to 40,000. To 40,000. Then at the end of year 2, if we go another year forward, the value that we keep the trucks on the books for will go down to 20,000. Then at the end of year 3, it's going to go down to 0, and then we go buy another truck, so we'll go back to 60,000; we'll keep going. The cool thing about this is it makes the expense very consistent, and actually more consistent with what our business is actually doing.