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Amortization | Stocks and bonds | Finance & Capital Markets | Khan Academy - YouTube
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In the depreciation video, we
saw that if a company had to
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buy some equipment for its
factory, let's say at the
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beginning of 2007, just based
on the cash that went out of
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the door, there might have been
this temptation to say,
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OK, in 2007, we had an
equipment expense.
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EQ expense.
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And they could have just
wrote, let's say that
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equipment cost $50,000.
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So they would have just put a
$50,000 expense right in 2007.
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I write it as a negative number
just because I like to
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remember it's an expense,
although normally people just
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write it as a positive expense,
but I always like to
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put a negative for an expense
to know that it's going to
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subtract from your revenue.
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So they would put that cash
expense there in 2007.
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And then in future years, maybe
2008, 2009, 2010, they
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would have no expense until
maybe they had to replace that
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machine or buy a new one.
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And we saw that that is one way
to account for things, but
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it really doesn't reflect the
reality of the business.
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The fact that this machine right
here that cost $50,000
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is used for-- in this example,
in the depreciation video, it
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was usable for two years.
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Let's say in this example, it's
usable for four years.
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So what they do is, instead of
just expensing the cost of the
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machine, when the machine is
bought on the balance sheet at
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the beginning of 2007, they
say, we now have an asset
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called a machine.
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I'll just call it
M for machine.
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That's $50,000 at this point
right here, right when we
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bought the machine.
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Remember, balance sheets
are snapshots in time.
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And then instead of having an
equipment expense, instead of
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having that expense, they'll
have an equipment
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depreciation expense.
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And the difference here is
instead of saying that the
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entire expense was that machine
in just the first
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period, they're saying no,
we're using some of the
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machine in that period.
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And let's say we do a
straight-line depreciation,
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which means we essentially
depreciate the asset evenly
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over its lifespan.
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So in this case, we're assuming
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it's a four-year lifespan.
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So let me draw that out.
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So the asset should linearly
go to zero
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over these four years.
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So essentially, in the
first year, our
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expense would be what?
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It's $12,000.
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If you divide $50,000
by 4, it's $12,500.
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It would be minus $12,500 in
each year, depreciation
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expense, and we would account
for it on the balance sheet.
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Because remember, income
statements are just telling
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you how do you get from one
balance sheet to another.
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So expenses reduce the
value of your assets.
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So, for example, in this one,
at the beginning of the
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period, before the 2007
income statement, the
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asset was worth $50,000.
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We depreciated $12,500 from it,
so at this point in time,
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the balance sheet as of the end
of 2007 or the beginning
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of 2008, we're going to say
that our machine is now
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$12,500 less, so $47,500.
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And then at the end of 2008,
beginning of 2009, our balance
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sheet under the assets, the
machine, if they gave us that
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level of granularity, would
be $12,500 less than that.
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So that's what? $37,500.
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So then the machine
is $25,000.
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And then another $12,500
on the books.
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It'll say the machine
is worth $12,500.
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And then at the end of
2010, it'll say the
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machine is worth nothing.
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And if we did our depreciation
schedule right, or if the
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lifespan of this machine really
is four years, then
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it's time to go buy another
machine and start doing this
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all over again.
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This is all a review of the
depreciation video.
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Amortization is the exact same
thing, but it deals with
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intangible assets.
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What's an intangible?
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It's something you can't see,
touch, feel, smell, eat.
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Obviously , a machine you can't
do all of those things
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to it, but you can at least
touch it and possibly smell
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and taste it.
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So an intangible asset, we can't
do any of that stuff to,
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but it's the exact same idea.
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For example, let's say we are
some type of widget company.
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And let me write down
the years: 2007,
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2008, 2009 and 2010.
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And let's say that if we just
did it from a cash point of
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view, let's say we had
to buy a patent in
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order to make our widgets.
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So we could have said, oh, we
have to buy a patent expense.
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We had to buy a patent
from some
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brilliant inventor someplace.
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We could just say, oh,
you know what?
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The patent cost $4,000.
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So we could just put that there
even though the useful
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life of the patent might
be four years.
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And so it doesn't reflect the
fact that we still are using
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that patent in these years, and
we just take the hit here.
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So this income will look
unusually low, while these
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will look unusually high.
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It's not reflective of the fact
that you're using this
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patent that has four
years left on it.
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So instead of doing that, what
you do is, at the beginning of
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the period you say, we have
acquired a patent, an asset,
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that is worth $4,000, And then
every year over the life of
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the patent, we'd amortize a
fourth of it since it has a
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four-year life.
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So it would be patent
amortization.
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And there's all sorts of
intangible assets that you
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might amortize.
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And amortizing really just means
spreading out the cost
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of this asset, just like
depreciation was spreading out
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the cost of a physical asset.
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So patent amortization would be
$1,000 in this year, $1,000
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in this year, $1,000 in this
year, and $1,000 in this year.
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And then our snapshot, or our
balance sheet at the end of
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2007, will have on its
assets a patent
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that's now worth $3,000.
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And at the end of 2008,
it'll have a patent
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that's now worth $2,000.
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The end of 2009-- I think you
get the point-- you'll have a
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patent worth $1,000.
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And at the end of 2010, probably
because the patent is
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now expired and anyone can go
out and produce whatever that
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invention that was patented
without having the patent, we
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then say that the patent
is worthless.
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And a very relevant thing is if
you were a drug company and
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you were buying the patent to
some pharmaceutical that had
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four years left so that you
could have exclusive rights to
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develop that drug. and at this
point, all of a sudden, now
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anyone can develop the drug, so
that patent is worthless.
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So the balance sheet is really
trying to capture what your
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asset is worth at that
point in time.
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At this point in time, your
patent is arguably only worth
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$1,000, because you paid $4,000
for four years, and now
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you only have a year left.
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But that's all amortization
is.
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Nothing fancy.
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Really, in my mind, it's very
similar to depreciation.
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Depreciation is tangible.
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Amortization is intangible.
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It could be patents, it
could be licenses.
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It could be fees associated
with the financing.
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Let's say you have some debt
that you took from a company,
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and the debt is going to last
for 10 years, and you had to
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pay a one-time lump-sum
to the bank.
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Well, that one-time lump-sum fee
should probably be spread
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over the life of the debt, so
you would amortize that
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expense over its life.
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Anyway, see you in
the next video.
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