Welcome. In this module, we're going to discuss how firms think about long lived assets that they use in their operations. As firms create value, they often use assets that have long lives. Some portion of the value is used up every period, and some remains. From an accounting standpoint, this means we have two questions. What assets do we have now? And how much asset value was used during this period? The accountants often called that depreciation or amortization. It might help to take a look at a little timeline and think of a simple example here. First, imagine an asset that we purchased during the year and by the end of the year we've already disposed of the asset. It's pretty easy to know what's happened with that asset. If we didn't get any sort of salvage value out of selling it, then we can say the entire value was used up this period. And if we did sell it for a little something, then we can just subtract that out of what we spent. But it's pretty easy to come up with how much value was used this period. And we know at the end of the period, we've got zero value left. But now imagine that, that asset actually gets used over a couple of years. So we get to the end of the first year and now we have to answer those two questions. What portion of the asset still remains within the firm and how much of the asset was used? And then the next year, we're going to have to answer that question again, how much of that asset was used? Even after we've disposed of it, we're not exactly sure how much asset was used in each one of the periods, we're going to have to make an estimate about that. So as we think about this, maybe it will help if we turn to an actual asset. Let's go back to those espresso machines we talked about in some of our earlier videos. Imagine that you purchased an espresso machine for your personal use. You know how much you paid for it upfront and your plan is to use it for a latte or espresso each morning, maybe if you have friends over for a meal, you'll make them an espresso for afterwards. And when you do that, one of your friends says, well, do you really think this made sense? How much does it costing you to make these espressos? You can tell them, well, I know what I spend up front, and you can think about how many expressions you're going to get out of it. Now, may be one of your friends is one of those know it alls, probably an engineer. And they tell you, well, it's not really the number of expressos you're going to get out of it because as this is machine gets older, the valves on it starts to wear out. So, may be they'll tell you it's number of years instead. And, you tell them, I'm just going to use it until it falls apart. So there's no sort of salvage value for it. You can try to figure out how much each espresso's going to cost you using all that information. Now, imagine the same espresso machine was purchased by a coffee bar, as soon as they buy it, they have to spend extra money to direct plumb it. Maybe there's criteria to kind of bring up the code to be used in an actual restaurant. That might mean that they might have to upgrade some of the electrical in order to make something that's easier to clean. So, they've put extra money on it. Now, they are going to use it at non-stop. It's going to keep turning up espressos, which means they're going to get a lot more espressos out of it in a year than you do. Their plan is to sell it in a couple of years because the technology in these is changing all the time and becoming more efficient. So they're going to think about, how much are we going to get for that when we sell it, as well? Even though it's the exact same asset, you and the coffee bar use it very differently. And the way that you're going to think about, whether you created value or not, differs a lot as well. Accountants find that they have to think of this the same way. So how do they do the accounting? Well, the first thing that they do when you buy a long lived asset is they determine whether it's really going to be an asset, or whether it's just a cost of this period. You might recall our definition of an asset. First, does it have probable future economic benefit? Second, is it under your control? And third is, was there a past transaction? In the case of the espresso machine, they're going to use that to create espresso in the future that they're going to sell. So it's got probable future economic benefit. They control it and they are already purchased it. Knowing that, they can turn to what they need to do to be able to depreciate that asset over it's long life. So what does the accounting require in that situation? Well, we are going to need to know how much we pay. The total acquisition cost of the item. How long or how much you will use it, it's specific to your company. What's the worst is going to be at the end, that is, are you going to be able to sell it and get any salvage value out of it? And then, finally, what sort of allocation method you want to use. Let me give you an example of how we might pull all this together. Well, we could take our total acquisition cost, subtract out our salvage value, and then divide through by the useful life. This would be something like we would do, if your friend's right, and for our machine, we really think it's going to be spread over time. Now, we may also do that, even if we work in that espresso shop because it's simpler just to think of how many years of value you're going to get out of something. However, we could divide through by something like the number of units. In this case it would be the number of servings of espresso you're going to be able to make. Either way, I want you to notice that in the numerator, what we've done is taken the total amount of value that we've invested in the firm minus whatever value we're going to get back. The net of those two is the total value we're going to use up and then we're figuring out somehow to divide that through and come up with a value per some sort of time or unit, etc. Now, when we do this, there's going to be measurement issues. We're making big estimates and that's a big part of the problem. Think about how far into the future you have to predict the use and the value that it's going to give you. Imagine, for example, that you buy a new building, you say a retail store, and you're thinking that building might last 80 years. It's really hard to predict what's going to happen over that 80 years. What's future demand going to be like etc? Think of our espresso, the technology may change and we don't know exactly when, so we don't know exactly how long we're going to keep that. All of this uncertainties is embedded in the estimates that we're going to make. Now it gets even tougher because it's based on a specific firm's use. Some firms may say, we buy an espresso machine and we use it forever. Then the economic life and the useful life for the firm are exactly the same. But lot's of firms may say, well, we sell ours quickly, and we only use it for a little time. Think of two different firms buying cars, one firm may it's really important for us that our cars are up to date and new because we drive clients around in them. The other says we just use them for hauling things and so we'll use them until they run on to the ground. This makes it really tough because it's hard to compare to other firms. It also causes a problem if your business model or competitive position changes over time. And then the base problem with all of these is you really can't observe true usage as it occurs. Even if we think about something like that car or an airplane that can tell us number of miles flown, well, the starts and stops, city traffic may be different than traffic on a highway, etc. And there we're at least lucky they were getting sort of a mileage. With that machine, it likely doesn't tell us at the end of the day how many glasses of espresso were made. And so, we just look at this and come up with some sort of metric of usage over time. And, of course, anytime that we have measurement error, we also have management bias. The long term nature of these items means that it's going to take a long time for any sort of bad assumptions to show up. This create real temptation for management. Imagine that you are that manager buying that long term building, you think it's going to last 70 years. But if you tell people it's going to last 80 years, that's a little less of a charge for you each year. And, by the time we hit the 70th year, you'll be long gone. Any sort of long lived asset can create that temptation. Now, there's another issue, and we're going to talk in a future video about what happens if you reassess your estimates about how you're going to use an item. But when are managers most likely to make those reassessments? And usually, if they make a reassessment, it's we're going to use it longer, which stretches out the life. Well, they're most likely to make those reassessments when things are tough. Think about this yourself, if you usually buy a car every three years but you're in a down period in that third year. Well, you're likely to say, hey, I can make this car last a fourth or a fifth year. When the manager makes that same decision, it lowers their depreciation during the current period. The problem with that is that they also can make that decision just to make it look like they're using up less of the item, even though they don't really intend to make the changes. Outsiders can't separate it out, is it really a change in the business actions? Or is this just a change in what they're telling outsiders is going to occur? Finally, there's this incentive to cherry pick when you sell an item. We're going to do a video about that too, the way that you generate gains and loses. But for now, let me just tell you that depending on which item you sell, you may be able to create some higher net income during the year if it's an item that has some attributes. Or in other cases, you may be able to actually create a loss. So if you're having a good year and you want to smooth earnings out, you could take that loss this year. In the next video, we're going to talk more specifically about how to do the accounting for long lived assets.