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Depreciation is the way accountants measure of how used up a thing is.
Imagine that you have a car. Over the past 10 years, you've driven it 200,000 miles over rough terrain.
The car still works, but the car has been dinged up, parts are wearing out, and the underside is starting to rust.
It should be pretty obvious that the car is going to be worth less than when it was new.
Accountants call estimated how used up something is as depreciation
One of the simplest methods of depreciation is to reduce the value of an item by the same dollar amount each year. This is called straight-line depreciation.
Why is it called straight-line?
If you were to make a graph with value on the y-axis, and time on the x-axis, you'd see a straight diagonal line.
Of course, there's a complication. Most items get depreciated and then stop depreciating any further. It would be weird, for instance, for a car to be so depreciated to be worth less than zero dollars. That could lead to strange situations. Imagine saying that your old car was worth negative one million dollars. Doing so wouldn't make any sense.
For that reason, depreciation stops at either zero, or something called residual value.
What's residual value (also known as salvage value or scrap value)? It's the value that an item has when it can no longer by used for its original purpose.
A car, for instance, can be sold to a metal recycler who will scrap it.
Here's how to calculate straight-line depreciation:
- Figure out how much depreciation will occur: Get the difference between the item's original value and its residual value
- Calculate the depreciation each year: Divide that by the estimated number of years of life. Note that this depreciation percentage is the same each year, but the dollar value gets smaller each year.
- Figure out the total accumulated depreciation: Multiply the depreciation each year by the number of years that passed
- Reduce the original purchase price by the accumulated depreciation