[MUSIC] In this video clip I'm going to introduce a new accounting concept. Remember when we talk about the purchase of furniture and equipment at the year x0? That I tell you, will this asset last forever? The answer obviously is not. And actually, Christina had estimated a useful life of 5 years for the furniture and equipment. The reasons for this limited life can be multiple. First, obsolescence. Second, the assets just are worn down by the usage. Or third, simply that Christina wants to change this asset every five years. Just as part of a strategy, maybe to communicate a quality to the customers. Whatever is the reason, we need find a way to account for this loss of value over time of the assets. So, lets think about how to account for this. Three options come to mind. So the first one would be, okay, at the moment of purchase we recognize the full value of the asset, 25,000 euros of furniture and equipment. And we don't do anything with it, until the end of year x5. At the end of year x5, the life of this asset is over, and then we recognize a total decrease in the volume of the asset of minus 25,000. And an expense in our PNL account of 25,000. So all of a sudden we are poorer by 25,000. Now, how do you like this method? Does it really reflect the true and purview of the business? Let's think about this. So if you take the asset, the balance sheet at the end of the year x0 at the moment of purchase, you're going to see that the value of this asset is 25,000. If you take the balance sheet at the end of the year x4, you're going to see that the value of the asset is the same. Does it really make sense that the value of the asset is the same in year x0 and year x4 after four years of usage? Clearly this is not an option. Let's go for the next one. In the second option, we recognize the furniture and equipment at the moment of purchase as an expense. So we don't recognize an asset. From year x0 the value of this asset is 0 until year x5, why? Because we already recognize an expense in the very first year. How do you like this option? Does it really reflect the true and purview of the business? Well, not really. Because in year x0 or year x1 obviously this has a future value, this furniture and equipment is going to generate future benefits for the company. We own it, we control it. It's a result of a past transaction, and it will generate future benefits. That's the definition of an asset. Therefore, we should recognize this as an asset that has a future value. So clearly option two is not good either. Now, probably the best option is going to be something in between. So instead of recognizing a full expense in the beginning, or full expense at the end, what we're going to do is to allocate the purchase costs over the years. So we're going to recognize an expense every year. This allocation of the purchase costs over the useful life of the assets is called depreciation in the case of tangible noncurrent assets. And amortization in the case of intangible noncurrent assets. In any case, depreciation and amortization always applies to known current assets. So it doesn't apply to current assets. For example, inventory. We expect to sell inventory in the next few months, therefore we don't need to depreciate or amortize inventory. Therefore, these two concepts apply only to known current assets. Okay, let's account for the annual depreciation of the furniture and equipment. In order to estimate the annual depreciation, we need three elements that managers have to estimate. The first thing is the useful life of the asset. So Christina estimated that the useful life of furniture and equipment is five years. That's a subjective estimation. Second, the salvage value. So, that is the value that we expect that asset to have for the end of the useful life. It can be scrap value. Let's say that you have a car. And at the end of the useful life of the car, you sell it just as a scrap value. Or it can be like the value in the second-hand market. In the case of the car, there are these blue books where you can get the price after a few years. So you can estimate that that is a salvage value. In this case, a salvage value for furniture and equipment is 0. The third thing that you need is the depreciation method or amortization method. And this is the way you allocate the rate at which you allocate the purchase cost over the years. In our case we are going to use the straight-line method, so we are going to depreciate the same amount every year. Actually, this is the most common method, and therefore for this course we are only going to use this method. So the annual depreciation of the furniture and equipment is going to be the 25,000, the original cost, minus the salvage value. That is 0. Divided by the useful life, which is 5 years. So we are going to allocate the cost of 5,000 euros to every year. Therefore, the first thing we need to do is to recognize a decrease after the first year, a decrease of the value of the asset of 5,000 euros. Now, one option would be to decrease directly the value of furniture and equipment. But normally what you have to do is to use an account that is called accumulated depreciation. So it's an account that shows in negative right below the furniture and equipment, right below the asset. Now, why do you think that we are doing this? Why do you think that we are keeping this accumulated depreciation in a different account? The reason is that by recognizing the depreciation in a different account, you always keep track of the original cost of the asset. In this case, for the furniture and equipment, 25,000. And at the same time you know the portion of these total original costs that has already been depreciated. So, as a shareholder, if you see that only 10% of the original cost has been depreciated, probably you don't have to worry about making new investments. However, if you see that 90% of the original cost has already been depreciated, start preparing your wallet because next year you have to make new investments. So in the one hand we are going to recognize the decrease in the value of the asset. In this case, 5,000 euros. And we do this through accumulated depreciation account, which is a contrasted account. It's called a contrasted because it's an asset that shows always in negative, subtracting from another asset. And on the other hand we are going to recognize that now we are poorer because we have an asset that has lost value. And this value is gone. So, the net worth of the shareholders has decreased by 5,000 euros as well, and that's a depreciation expense we recognize in the PNL account. So little by little the asset we recognized in the beginning, the purchase cost that we recognized for the furniture and equipment, is going to be allocated to the PNL account as an expense. So, by the end of year X5, the end of the useful life, the net value of furniture and equipment is going to be 0. Great, if you understand this case, let us now recognize the amortization for the software. Remember, that Christine estimated that the software has a useful life of three years. She's going to use a straight-line method, so we're going to reconnect the same amount of amortization every year, and the salvage value is zero. So we assume that after three years, the software is totally obsolete, and so the value is zero. I will need to buy a new version. General amortization expense is going to be 3,000 euros, the original cost, minus established value, which is 0 divided by the useful life, 3 years. Therefore, it's going to be 1,000 euros per year. Now, we need to recognize that increasing the value software of 1,000 euros, and we go through the accumulated amortization. So an account that shows in negative right below the software. In addition, we need to recognize that now we are poorer. There is an asset that has lost value and therefore as shareholders in this company, our net worth has decreased. So we recognize an amortization expense in the PNL account. Again, remember that amortization and depreciation are the same concept. Amortization applies to intangible noncurrent assets. Where as depreciation applies to tangible noncurrent assets. And as I've said before, current assets do not experience depreciation and amortization. So, for example, inventory. We are selling it in a few months and therefore we don't need to recognize any depreciation overtime. In summary, depreciation and amortization is an allocation of the purchase cost of the asset over time. [MUSIC]
