You’ll often hear the words
depreciation and amortization used together. And what I want to
do in this video is to understand a little bit
better why they are similar and the slight difference
between the two. So in our previous examples,
we’ve done depreciation. And so you could
imagine in period zero we buy a truck for $60,000. And instead of just
expensing it in period zero, instead of putting $60,000
expense right over here, we capitalize it. We say that we have
a $60,000 asset. And so this is right at
the end of period zero or at the beginning
of period one. And what we do is we
spread out this expense over the period of time
that we’re actually going to use the truck. So in period one, we depreciate
the truck by $20,000. We’re assuming we have a
three year life of this truck. And we’re just
going to do what’s called straight
line depreciation. We’re just going to take
the cost of the truck and divide it by its life. There’s other ways
to depreciate it. Maybe you could imagine
that it depreciates faster in the first year, but
this is the simplest type. And it’s actually used by
a lot of companies, just straight line depreciation. So after we use $20,000,
we depreciate the truck by $20,000. We expense it in that year. So this is literally an expense. Then at the end
of period one, it is now on our books for $40,000. Then in period two,
we depreciate it by another $20,000. It is going to be an expense, a
$20,000 expense in period two. Now on our books at the end of
period two, it’ll be worth 20. Then in period three, we
expense another $20,000 on our income statement. And then on, at least for
just this truck, assuming we haven’t bought a
new one yet, we’ve completely written it off. It is now worth
zero on our books because based on
what we assumed, it’s not useful anymore. We kind of have to
scrap this truck. That’s depreciation. Now imagine if to run our
trucking business we also have to pay some
type of license fee. So let me call
this a license fee. And let’s say that the
license fee was $4,000. And we get to use
it over four years. So once again, you could
have just put a $4,000 expense right over here, but
that’s not really accurate. You’re not just using
the fee in that period. That fee is going to be useful
over the next four years. So once again, you would
put down the asset, the paid license fee or maybe
the prepaid license fee depending on how you view it. And then you would
amortize that cost, which is essentially the
same thing mathematically. You’d say, look, I’m going to
use this over the next four years, essentially
$1,000 a year. So my license fee amortization
in year one I’d say is $1,000. And then on my books I
would carry the license fee for $3,000. Then I’d amortize
another $1,000. Then it would go down to $2,000. Amortize another $1,000. Then at the end of
period three, it’s now worth $1,000 on my books. Period four, amortize
another $1,000. Now I’ve completely
written it off and I probably have to get
another license at this point. So mathematically,
they’re the same thing. Even philosophically,
they’re the same thing. The idea that instead of
expensing these expenses all at once you’re saying, look,
they have some useful life. Let me spread out the expense
over their useful life. The difference between
the two– and you might have already
kind of realized this– is depreciation is
when you have hard assets. If you have a
building or a truck or some type of equipment, you
would depreciate that asset. If you have a non-hard
asset or a financial asset or something that’s
less tangible, then you would just amortize it. This is just kind
of a different word depending on how
tangible the asset is. So if it’s a license fee
or some other type of fee or some type of it maybe
intellectual property, you would amortize the cost. If you have a truck or
a building or whatever, you would depreciate it.