Notion of Depreciation and Amortization

Core Idea: To quantitatively reflect the value of an asset over time, giving a numerical measure (not just qualitative assessment like 'better' or 'worse').
Quantitative Measure: A key term, emphasizing assigning a number to the asset's evolving value.
Recording Acquisition: When assets (e.g., instruments) are bought, their acquisition is recorded at the price paid, known as 'at cost'.

Definition: The act of defining how a company will depreciate or amortize its assets. Every company must define one and clearly explain it.
Components of a Depreciation Policy: Should outline:
- The specific method used (most common is the straight-line method).
- The estimation of the asset's useful life.
- The asset's expected residual value at the end of its useful life (intangible assets typically have no residual value).
- How the depreciation will be recorded in financial statements.
- (In footnotes for some companies) any provisions for impairment.
- Calculation of salvage values (if applicable).
- Documentation of any revaluation or adaptation of assets.

Formula: The most common method for calculating depreciation expense.
$\text{Depreciation Expense} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}}$
Cost: The initial price paid for the asset.
Residual Value: The estimated scrap or salvage value of an asset at the end of its useful life. (Crucially, intangible assets like music catalogs often have no residual value).
Useful Life: The period over which the asset is expected to generate economic benefits for the company.

Subjectivity: The concept of 'useful life' is often vague and subjective, especially for intangible assets like songs.
Music Industry Example: The useful life for a song catalog has shifted from around $5$ years to $10$ years due to streaming platforms extending the earning potential of older music. Legacy artists' catalogs (e.g., Michael Jackson, Madonna) may be amortized for $40$ to $50$ years.
Impact on Profitability: Adjusting the useful life directly impacts the annual depreciation expense, thereby affecting reported profitability. For example, a $\$2,000$ computer depreciated over $10$ years incurs $\$200$ annual expense. Depreciating it over $2$ years increases the expense to $\$1,000$ , decreasing profit.

Two Accounts Impacted: Depreciation (and amortization) affects two key financial statements:
1. Income Statement: A depreciation expense is recorded, reducing the company's reported profit.
2. Balance Sheet: An accumulated depreciation account is created, which is a contra-asset account, reducing the book value of the asset over time.
Journal Entry Example: When an asset is purchased and depreciated:
- Initial Purchase: Debit Long-Term Asset (e.g., Computer), Credit Cash.
- Adjusting Entry (Depreciation): Debit Depreciation Expense (Income Statement), Credit Accumulated Depreciation (Balance Sheet).

Long-Term Assets: Generally, land is not depreciated, but buildings on it are.
Intangible Assets: Trademarks are typically not depreciated because they have an indefinite useful life (they exist as long as the company maintains them and can be continually renewed). Copyrights, however, have a definite useful life (creator's life + $50-70$ years) and are depreciated.
Leased Assets/Licenses: If a company leases or rents an asset (e.g., Ableton software license for \unicode{x20AC}12/\text{month} ), it's considered an operational expense, not an amortizable asset, as the company doesn't own it.
Financial Investments: Stocks and bonds are not depreciated.

Net Income: The legal accounting definition of profit, calculated after all expenses, including interest, taxes, depreciation, and amortization.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):
- Financial Analyst's Metric: Not a formal accounting metric but widely used by financial analysts.
- Purpose: To arrive at a measure of operational profitability by excluding depreciation and amortization (D&A), as D&A is largely an estimation.
- Reason for Exclusion: Financial analysts view D&A as easily manipulated due to its reliance on subjective estimations (e.g., useful life), which can lead to discrepancies between real value and reported figures. Excluding it offers a clearer view of cash-generating capability from core operations.
- Manipulation Concern: Companies can adjust depreciation policies (e.g., shorten or lengthen useful life) to influence reported profitability, which can mislead investors.

Example: Spotify, despite having been profitable only twice in $12$ years, is valued at approximately $\$151$ billion. This illustrates that reported profitability (influenced by D&A policies) isn't always the sole or most important metric for market valuation, especially for growth-oriented tech companies.

CFO and Auditors: The Chief Financial Officer (CFO) is responsible for the accuracy of publicly signed accounts. They share liability with external auditors (e.g., PricewaterhouseCoopers, KPMG, Ernst & Young) who attest to the correctness of financial statements for public companies, ensuring investor confidence.
Estimation Discrepancy: Due to the estimation inherent in D&A, there can be a discrepancy between a company's perceived market value and its book value (assets as recorded in financial statements).

Annual Practice: In the music industry, intangible assets (like song catalogs) are often revalued or assessed for impairment annually.
Revaluation Surplus: Occurs when an asset's value increases (e.g., land in a booming real estate market, a song becoming a TikTok hit).
Impairment Loss: Occurs when an asset's value decreases significantly or becomes worthless (e.g., a brand losing trust due to scandal, a recording studio being destroyed).
Recording Asset Sales: When an asset is sold, the transaction records the cash received, removes the asset's cost and accumulated depreciation from the books, and recognizes any gain or loss on the sale. A gain on sale of assets is recorded as revenue, while a loss on sale of assets reduces profit.
- Example: Asset bought for $\$13,000$ , with accumulated depreciation of $\$3,500$ , has a book value of $\$9,500$ . If sold for $\$10,000$ , a gain of $\$500$ is recorded.

Definition: Represents the difference between the market value of a company (or an acquisition price) and the fair value of its identifiable tangible and intangible assets. It captures things not easily quantifiable, such as:
- Brand name and reputation.
- Customer information and relationships (data).
- Proprietary technology, algorithms, or patents.
- Synergies or future growth potential.
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