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You've already learned about the straight-line depreciation method.
It's straight-forward, it's easy, it's also problematic.
It assumes that items will lose value at a constant rate, until they've hit their residual value (which may or may not be zero).
There are many things, however, that lose most of their value early in their ownership.
- New cars are said to lose 30% of their value as soon as they are driven off the lot.
- Computers that are world-class in terms of processing power are soon overshadowed by newer and more powerful devices.
- Sailboats tend to lose value extremely rapidly early in their lives and then bottom out at a stable price a number of years later.
The straight-line method under-estimates the depreciation on these items early on, and over-estimates it later on.
For some types of products, it would be wonderful to use a depreciation method that better reflects reality.
Such a method would be more accurate, and it would also offer some significant tax benefits, allowing for greater deductions for the loss of value early in the ownership period.
The phrase double-declining should clue you in that the rate of depreciation is double what it would be under straight line.
Here's how it works:
- Divide 1 by the item's lifespan in years.
- Double it to find the depreciation rate. This is the percentage that the value of the item that will be reduced each year.
- Each year, reduce the item's value by the existing value * the depreciation rate or the remaining value until the salvage value, whichever is lower.
Make sure you remember the following two points, as many accounting students forget:
- Unlike in straight-line, the depreciation rate is calculated without regard to the salvage value.
- The depreciation can never take the value of the item below its residual value. If necessary, the depreciation in the final year must be reduced from how it would otherwise be calculated.