Accelerated Amortization

  

Amortization. Big word. Let’s make it...smaller. We’ve got the root word “mort” in there, which means “death." And yeah, when you’re amortizing a loan, you’re...killing it. Softly. You’re gradually reducing your obligation by paying back whatever you borrowed. So that, once a loan is fully amortized, the amount you owe is...zero.

That’s one definition of the term. It’s also a fancy way of saying “allocate costs." You pay a thousand dollars for an amazing bed. Did you get value from it? Well, if you use it a lot, you’ll amortize the costs in such a way that the bed is...cheap. How so? Well, if you sleep on it for 2,000 nights before you toss it, you’ve paid 50 cents per night for your bed. That’s like a nickel an hour of use. And that assumes it’s just you in the bed. Giggity.

What about a prom dress or tux? Well, the finest Walmart prom dress runs about 300 bucks. But you wear it once before Tyler Hendricks vomits on it, and then you’re done. So it cost 300 bucks a night, or about 50 bucks an hour, for the 6 hours you wore it. Way expensive per use, because you only had 6 hours of amortization.

Loans work the same way. You borrow 120 grand to buy a home with a 30-year mortgage. Over those 30 years, you amortize the loan, or allocate the paying-down of that 120k you just borrowed, over a long period of time.

So...something to keep in mind the next time you go shopping for a bed…or a dress.

Related or Semi-related Video

Finance: What is Double Declining Balanc...10 Views

00:00

Finance a la shmoop what is double-declining balance sheet

00:05

depreciation kind of sounds like that strange-looking British double-decker [Buses in London]

00:10

bus right but it's not instead it's a structure or formula under which [Definition of a double declining balance sheet]

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companies assess the depreciating value of an asset that you know loses value

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it's basically the way they lose or track the loss of value in it that's [Guy talking on a London street]

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different from normal depreciation like a tractor smelting Factory or the break [A bucket of molten metal being poured]

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room vending machine which used to deposit KitKat bars but has been hanging [KitKat bar gets stuck in the machine]

00:35

on to that one bar since 1992 we got to depreciate those well if Shmaterpiller

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has a smelting Factory they paid a hundred million bucks to build which [100 million bucks price tag appears]

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will be sold for salvage value or scrap for ten million bucks in 20 years then

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the decline in total value over that time will be ninety million bucks yep [Decline in value calculation]

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over twenty years or four and a half million dollars each year if the company

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used straight-line depreciation to account for the loss in value of that [Straight line on a value/time graph]

01:04

smelting Factory but under double declining balance depreciation systems

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the deduction rate is essentially double the straight-line amounts it's still the

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same total amount of deduction it's not like the value of the tractor factory

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changed either at purchase time or scrap time but the speed and timing of the [Timeline of depreciation]

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depreciation changed to favor high depreciation in the early years giving

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the company lower profits but also lower taxes [The first 5 years on the timeline are highlighted]

01:32

well the accounting rationale follows suit the utility or value of the asset

01:37

is in fact not declining in true market value in a steady state straight-line [Stop sign appears over the value graph]

01:44

over twenty years try to convince a buyer that your car

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has depreciated only five percent in value a year after you bought it new [Car for sale on eBay]

01:51

yeah not happening depreciate way more than that so in double declining balance

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depreciation instead of deducting four-and-a-half million bucks a year the

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company would deduct nine million a year each year with some adjustments along

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the way and yes we're way over generalizing on that statement until [Overgeneralizing flashing red]

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that smelting Factory was fully deducted away to whatever terminal salvage value

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or scrap value they predicted it would then sell [Factory value declining]

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for that is if a normal depreciation was taking four-and-a-half million bucks a

02:20

year for 20 years or four-and-a-half percent of the total initial cost then [Straight line depreciation per year]

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double declining balance depreciation would take double that number or nine

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percent of the hundred million dollars in year one

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so they deduct nine million right upfront and your one right goes from 100

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to ninety one on the sheets and in reality that's probably a lot closer to [Price tag decreasing]

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what the actual loss and market value of the smelting machine and would look like

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all right well then in year two double declining balance depreciation would

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again take double the flat rate of that four inhabitant they double it to nine

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percent of the remaining book value of the smelter or nine percent of the

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remaining 91 million that it's worth or about 8.2 million in incremental [Double declining balance depreciation per year]

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depreciation for that year leaving the value ninety one - 8.2 or eighty two

03:08

point eight million dollars in year three the value of the shelter would

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drop another nine percent to about seventy five point four million say we

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did all the math therefore there no extra charge and in year four down nine [Post it note showing the calculation]

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percent again to around sixty eight point six million dollars so up to this

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point the set of deductions would look like this there we go all that stuff you [Amount depreciated in the first 4 years is shown]

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notice that as we've gone along here we've taken the beginning of the year

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book value of the smelter as the starting point against which to take our

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nine percent deduction if we take nine percent always well we'll never get to

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zero or rather to the scrap value target there of ten million bucks right nine [The value in the 20th year is shown]

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percent and keep just being a tiny tiny amount on those out years so in practice

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at some point when companies have depreciated the crap out of their

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capital assets well then they switch to straight-line depreciation in this case

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after say year five our smelter would be valued at sixty two point four million

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dollars ish with fifty two point four million left to depreciate to hit that

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ten million dollar scrap value for about three point five million a year for the [Calculation of loss per year is shown]

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remaining fifteen years until finally yes Bessie is a put out to pasture the [The factory is thrown into the trash]

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gist of double declining balance sheets appreciation is to let companies pay

04:23

less in taxes early in their history having more cash to

04:27

build their businesses and grow faster at the price of showing lower accounting

04:32

earnings and that's just okay with Wall Street so yeah here's to hoping they [Someone doing an okay sign next the Wall St. sign]

04:35

deploy that cash into after know something a little more fun [Money going down a water slide]

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What are Fixed Assets, Tangible Assets and Intangible Assets? Fixed assets are long term, illiquid assets that are necessary for a company’s oper...

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