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Depreciation | Stocks and bonds | Finance & Capital Markets | Khan Academy - YouTube
Channel: Khan Academy
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So we have a company here.
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Let's just say it's
a widget factory
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again or a widget company.
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And what I'm going to do is I'm
going to actually write
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out its income statement over
a given number of years.
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What we did in the first video
on this series is we just did
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one snapshot of the
income statement.
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I think it was 2008.
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But here we're looking at the
income statement over a bunch
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of years, and in this case, I'm
just assuming that they
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have a very stable revenue base,
that they bring in a
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very stable amount of
revenue every year.
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Now, their cost of goods, I'm
going to split up this time,
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because there's two components
of cost of goods, so I'll just
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make a cost of goods category
right here.
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COGS, but that just stands for
Cost of Goods Sold, but
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sometimes you'll hear someone
say our COGS were this or our
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COGS were that.
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Cost of Goods Sold.
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So they're the variable costs.
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And this video isn't a video
on variable versus fixed
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costs, but you might learn
a little bit about it.
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So they're the variable costs,
and that's literally the
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actual costs of making
those widgets.
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So if the widgets are made out
stainless steel, it's the cost
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of buying the stainless steel
and maybe the electricity bill
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of melting it and reforming it
or however you have to work
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with stainless steel.
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So let's say the variable costs
each of these years--
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and I'm assuming stainless
steel prices
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don't change-- is $100,000.
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Minus $100,000 every year.
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And actually, let's
just say that also
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includes employee costs.
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They have people on hourly wages
that are forming these
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stainless steel widgets, so that
incorporates everything.
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And then the fixed costs
will essentially be
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the cost of the factory.
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And let's say that they
essentially have to build a
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new factory every two years, or
let's say they have to do
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major repairs to the factory
every two years.
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So let's say repairs
on factory.
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Because that's part of the cost
of building the widgets,
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because if you continue to make
widgets at this kind of
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$1 million a year pace, your
factory has to be retooled or
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revamped every two years.
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So let's put this fixed cost.
So the factory retooling.
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And most times, and we'll see
this when you look at an
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actual company's income
statement, they're not going
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to break up the variable and
fixed costs within their cost
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of goods sold like this, because
really, they actually
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want to hide it from a lot
of their competitors.
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They don't want their
competitors to have too much
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intelligence on what their
cost structure is like.
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It could be used against them
potentially, or maybe they
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don't want their customers
to know.
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Anyway, factory tooling.
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So the way I just described it,
one way to account for it
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is when you do the factory
retooling, you essentially
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just mark it as an expense.
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So let's say a factory retooling
costs $500,000.
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So let's say it's
minus $500,000.
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But they do it every
two years.
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So you did it in 2005.
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They didn't have to do
it in 2006, then they
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can do it in 2007.
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They don't have to
do it in 2008.
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Fair enough.
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And then we have their
gross profit.
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Here it's $1 million
minus $600,000.
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It's $400,000, then it's
$900,000, then it is $400,000,
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then it's $900,000.
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And let's say that their
SG&A-- SG&A is Selling,
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General and Administrative
expenses.
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I'll leave out marketing
for now.
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They're SG&A, let's say it's
another $500,000 every year.
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So minus $500,000.
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And that never changes.
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$500,000 every year.
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Minus $500,000.
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And so their operating profit,
the amount of pre-tax income,
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but you know, we're not
considering financing either,
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so this is their operating
profit or their EBIT.
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So operating profit.
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And this year, it's
minus $100,000.
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Here it's also minus $100,000.
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But then in these years,
they make money.
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It's $400,000 and $400,000.
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And then we could
take this down.
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Let's say they have no
interest expense.
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They have no interest expense,
because that's not the point
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of this video.
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And then their pre-tax profit is
going to be the same thing
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as the operating profit, so
minus $100,000, minus
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$100,000, $400,000--
I'll make the good
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years in green-- $400,000.
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And then, let's just say they're
in the Caribbean and
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they don't have to pay taxes.
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Because that's not the point
of this, but you can apply
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some tax rate to this
and figure out what
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their net income is.
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But the point of this is, even
though their business is ultra
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stable, they do the exact same
thing every year, when we look
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at the pre-tax or the operating
income, or if we tax
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it, or even at the net income,
we see a super lumpy business,
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because in one year they
lost $100,000.
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If you're looking at the
business, you're like, oh,
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what a horrible business.
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But then the next year they make
$400,000, and then they
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lose $100,000.
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And you're like, gee, how
is that possible?
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That you have such a sleepy,
stable business that's just
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making COGS year in year out,
and they have the exact same
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amount of revenue?
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How is it possible that their
actual income is so lumpy?
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And I think you know, because
you have this every other year
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factory retooling, where they
have to spend $500,000 to
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essentially rebuild their
factory because of all of the
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wear and tear that happened
over the last two years.
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So the question is, is this a
good way to account for it,
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where when you have to--
I guess you could
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say-- buy new equipment.
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Let's say this $500,000 is to
buy actual new stainless steel
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shaping tools, so is it a good
idea to account for it only in
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the period that you spend it?
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Because it's not like you're
only using these tools in this
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period and that period?
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You're using these tools
throughout the period.
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So the answer is, well, no,
it's not a good idea.
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Because the whole purpose of
accounting is to give the
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person reading the income
statement in this case as
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accurate a picture of the actual
state of the business
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as possible.
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And this, in my opinion, isn't
an accurate picture, where it
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creates this huge lumpiness and
it creates the impression
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of a volatile business even
though it's a super, super
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stable business.
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So what you do, instead of just
saying, oh, I had to buy
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$500,000 worth of equipment in
2005, so I literally put a
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$500,000 expense there, and I
didn't have to do that in
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2006, so I have no expense.
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I had to do it in 2007,
so I put the expense.
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Instead of doing that, what
you do is-- I'll put the
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balance sheet down here-- so
whatever the balance sheet was
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in-- so I'll draw both hand
sides of the balance sheet.
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So this is the asset side
of the balance sheet.
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And just so you don't get
confused, there's always a
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liability side of the balance
sheet as well.
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So in 2007, maybe before I spent
the $500,000, right when
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I do it, I probably had $500,000
of cash sitting here.
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Let me write that down.
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So I have cash.
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I'll just put a C there.
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Cash, $500,000.
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And instead of just using this
an expense, and we'll go in
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the future on kind of how you
account for things in a little
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bit more detail and how you
actually do the debits and
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credits, but a simple way to
think about it, instead of
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using this $500,000 as an
expense, we just transferred
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this $500,000 to buy an asset.
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So when you use cash to buy an
asset, and that asset has a
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useful life that's more than
just that period, you're
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essentially capitalizing the
expense or you're essentially
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creating that asset on
the balance sheet.
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So instead of this $500,000 just
disappearing expense, you
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say, no, now I have-- let's call
it F for factory tools.
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I have factory tools worth
$500,000, and then that cash
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will go away.
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So your assets will not have
really changed, the absolute
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value of the assets.
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You'll have just had $500,000
going from cash
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to new factory tools.
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And so this might be at the
beginning of when you do it.
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Let's say this is 1/1/2007.
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And what you say is, I'm going
to use these factory tools.
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They're usable over two years.
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So what you do is you depreciate
the tools.
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So the way you'd think about
this is instead of having
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factory retooling, you could
say factory tool.
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Instead of retooling I'll
call that depreciation.
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I don't know if you
can read that.
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So it essentially spreads
out the cost of
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that $500,000 a year.
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So you say, I had a $500,000
piece of capital equipment,
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and its useful life
is two years.
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So I used half of
it in year one.
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So instead of putting $500,000
there, the depreciation is
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minus $250,000.
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Likewise, in this year, no cash
went out the door, but my
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equipment got a little
bit older, so I used
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half more of it.
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So it's $250,000.
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And then my equipment
is worthless.
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So this is in 1/1/2005.
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I have this tool that's
worth $500,000.
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Then on 1/1/2006, I will have
used half of the tool.
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So now this balance sheet-- I
copied the numbers, too, but
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that's 2006.
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I'm going from 2005 to 2006.
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So now I will have used
up half of it.
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So according to the accounting,
this equipment is
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no longer worth $500,000.
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It's now worth $250,000.
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You know, that actually
might make sense.
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Maybe if I were to sell it in
the open market, someone might
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say, you know what?
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I'm only willing to pay
$250,000, because you've
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already used it for a year and
it only has one year of useful
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life left, so it's of $250,000
of value to me.
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And then the other $250,000
essentially went to an expense
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called depreciation, which
is right there.
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So every year, you're going to
have this asset go down on the
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balance sheets by $250,000.
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So here at the beginning
of this year, the
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asset is worth $500,000.
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So I'll write that up here.
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So this is what the
asset's valued.
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I'll do it in this
orange color.
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So over here, let's say you did
it right at the beginning
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of the year, the asset's
worth $500,000.
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Now, it's worth $250,000.
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Now, the asset's worth zero, but
at the beginning of this
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year, you buy a new asset
worth $500,000.
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Then it's worth $250,000
again.
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And this is just an arguably
long-winded way of saying that
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the way you account for this
is you spread out the cost
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over time, over its useful life,
and this spreading out
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is called the depreciation
of an asset.
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And I'm running out of time in
this video, and I'll cover it
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in the next, but you might have
also heard of the word
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"amortization." Amortization
is to spread out a
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non-tangible cost over
a period of time.
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So for example, depreciation,
this was factory equipment,
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and it gets old as I use it,
so I spread out its cost.
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That's what depreciation does.
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And it accurately reflects
what's actually happening in
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the business.
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It's not like I didn't
have any cost here.
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I did have cost. I'm
using an asset up.
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So therefore, I put
it down there.
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Amortization is the exact same
thing as depreciation, but it
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applies to things that
aren't equipment.
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It applies to-- and I'll do it
in the next video-- but let's
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say I had one big expense in
terms of I had to pay a bunch
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of fees to the bank, but the
benefit of those fees are
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going to be over time.
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Then I would amortize
those fees.
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I'll do that in the
next video.
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Anyway, hopefully, you found
this vaguely useful.
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