Straight Line Depreciation is a depreciation method used to calculate an asset’s value that reduces throughout its useful life.
The straight-line depreciation method is the most convenient and commonly used, and it results in a few calculation errors only. The method is the highly recommended method to be used. We use this method when we do not know the asset’s consumption pattern over a specific time.
This article will also take a look at:
- How is the Straight Line Depreciation calculated?
- Example of Straight Line Depreciation.
- How is the Straight-line depreciation method applied in Accounting?
- When should I use the straight-line method?
- Advantages and Disadvantages of Straight Line Basis.
How is the Straight Line Depreciation calculated?
In a straight-line depreciation method, we depreciate the asset’s value so that the depreciation expense is evenly divided over the time of its useful life. The calculation steps involved in calculating the straight-line depreciation are as follows:
- Determine the initial cost of the asset that has been recognized as a fixed asset.
- Subtract the estimated salvage value (the estimated resale value of an asset at the end of its useful life) of the asset. It is easiest to use the standard useful life for each class of assets.
- Determine the estimated useful life of the asset. It is easiest to use a standard useful life for each class of assets.
- Divide the estimated full useful life (in years) into 1 to arrive at the straight-line depreciation rate.
- Multiply the depreciation rate by the asset cost (less salvage value).
Example of Straight Line Depreciation:
A company bought some equipment (new machine) and now wants to calculate the straight-line depreciation of that machine:
- Cost of machine (asset) = $100,000
- Cost of asset – Estimated Salvage value of asset:
$100, 000 – $30,000 = $70,000 => total depreciable cost
- Useful life of machine = 5 years
- 1/5years = 20% annual depreciation rate applied on each year
- 20% x $70,000 = $14,000 annual depreciation
|Year||Book Value (beginning of year)||Depreciation||Book Value (ending of year)|
You can see that it has reached its estimated salvage value over the five years end of the asset. The value of an asset should always depreciate to its salvage value.
How is the Straight-line depreciation method applied in Accounting?
We record the Straight-line depreciation by debiting the depreciation expense entry and crediting the accumulated depreciation entry in accounting. The accumulated depreciation is considered a special kind of asset. When an asset is credited, it has a negative balance, ultimately decreasing that asset’s value.
Other Methods of Depreciation:
In addition to straight-line depreciation, there are other methods of calculating the depreciation of an asset. Different methods of asset depreciation are used to more accurately reflect the depreciation and current value of an asset. A company may elect to use one depreciation method over another in order to gain tax or cash flow advantages.
1. Double-declining balance method
A double-declining balance method is a form of accelerated depreciation. It means that the asset will be depreciated faster than with the straight-line method. The double-declining balance method results in higher depreciation expenses at the beginning of an asset’s life and lower depreciation expenses later. This method is used with assets that quickly lose value early in their useful life. A company may also choose to go with this method if it offers them tax or cash flow advantages.
2. Units of production method
The units of production method are based on an asset’s usage, activity, or units of goods produced. Therefore, depreciation would be higher in periods of high usage and lower in periods of low usage. This method can be used to depreciate assets where variation in usage is an important factor, such as cars based on miles driven or photocopiers on copies made.
When should I use the straight-line method?
To deduct certain expenses on your financial statements
Depreciation is an expense, just like any other business write-off. So you’ll want to make sure you calculate depreciation properly.
Most businesses use straight-line depreciation for their books, although some use the double-declining or sum of years method because it results in more write-offs near the beginning of the life on an asset.
For tax purposes, the IRS has a very specific depreciation method called the Modified Accelerated Cost Recovery System, or MACRS. In some cases, the IRS might even let you deduct the full cost of certain assets (like computers, software, and office furniture) during its first year of use, which gets rid of the need for depreciation methods altogether. (Accountants call this a Section 179 deduction.)
But the IRS uses the accelerated/MACRS or Section 179 for certain assets, including intangible assets like copyrights, patents, and trademarks. Instead, you use amortization for those.
To figure out the value of your business
You can’t get a good grasp of the total value of your assets unless you figure out how much they’ve depreciated. This is especially important for businesses that own a lot of expensive, long-term assets that have long useful lives.
Whether you’re creating a balance sheet to see how your business stands or an income statement to see whether it’s turning a profit, you need to calculate depreciation. The straight-line method is a great way to do that quickly.
Advantages and Disadvantages of Straight Line Basis
Accountants like the straight-line method because it is easy to use, renders fewer errors over the life of the asset, and expenses the same amount every accounting period. Unlike more complex methodologies, such as double declining balance, a straight line is simple and uses just three different variables to calculate the amount of depreciation each accounting period.
However, the simplicity of a straight-line basis is also one of its biggest drawbacks. One of the most obvious pitfalls of using this method is that the useful life calculation is based on guesswork. For example, there is always a risk that technological advancements could potentially render the asset obsolete earlier than expected. Moreover, the straight-line basis does not factor in the accelerated loss of an asset’s value in the short-term, nor the likelihood that it will cost more to maintain as it gets older.