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.