What is straight line depreciation?
Depreciation is the financial value that an asset diminishes over time because of use, wear and tear or becoming out of date. This decrease in value is measured as depreciation. Assets, like equipment and machinery, are generally expected to depreciate over a defined amount of time.
Straight line depreciation is when an asset is depreciated in equal installments until it gets to its salvage value. An asset’s salvage value is the estimated amount of the asset’s worth when it gets to the end of its useful life. The straight line depreciation method is considered to be one of the simplest ways to work out the depreciation of assets.
The declining balance method is another way of calculating asset depreciation. This method calculates more depreciation expenses in the beginning and uses a percentage of the book value of the asset instead of the initial cost. With the declining balance method, the quantity of depreciation reduces over time and carries on until it reaches its salvage value.
Another way to calculate the depreciation of assets is the units of production method. This process is based on the asset’s activity, usage or parts produced. As a result, depreciation will be lower in times of low usage and higher when the asset’s usage increases. This method is useful when the difference in usage is important, for example, printers depending on the amount of pages printed and cars in relation to the number of miles traveled.
There are advantages to using both the straight line and the declining balance methods. You should choose the right one depending on your business needs. The straight line depreciation method is easier to use, which will result in less complicated accounting. However, the declining balance method can be more accurate when assessing the value of an asset, for example, if you buy a new computer for your business, it will lose more value early on. However, assets like real estate or furniture steadily lose their value over time, therefore the straight line depreciation method is more suitable in these cases.
Why use straight line depreciation?
Straight line depreciation is helpful for business owners as it allows them to buy equipment and supplies they need without having a drastic effect on profits. If you buy assets for your business, the purpose of the assets is to make your business more profitable. However, some assets will not provide a profit right away. In the beginning, buying some assets can affect your profits in a negative way for accounting purposes.
When you use the straight line method, you can spread out the cost of the assets over many years. This means that your assets will not adversely affect your profits in the year they were bought. You will be able to determine how your profits are affected by the use of the asset.
The straight line depreciation method gives you a realistic picture of your business’s profit margin using long-term assets. Straight line depreciation can be calculated on assets such as manufacturing equipment, vehicles, office furniture, computers, and office buildings. These types of assets are known as long-term assets as they are essential to operating your business on a day-to-day basis and lasts for more than one year. When you divide the costs of these assets, you are able to have a full view of your profit margins. The straight line depreciation method is useful because, instead of taking a hit in your accounting early on and then seeing exaggerated profits, your profits and expenses are evened out at an equal pace.
Depreciation is an income tax deduction that permits you to recuperate the cost of some types of property. This is an annual allowance for the deterioration, wear and tear and obsolescence of the property. For tax purposes, both tangible property, for example, furniture, iPads, and equipment and intangible property, such as computer software, copyrights, and patents are depreciable.
Before you are allowed to claim a depreciation tax deduction on your assets, the assets must meet the following criteria:
- As the taxpayer, you must own the asset. You are also allowed to depreciate capital improvement for the property you lease.
- You must use the asset for an income-producing activity or in your business. If you use the asset for personal and for business reasons, you are only allowed to deduct depreciation based on only the business use of the asset.
- The asset must have a determinable useful life of more than 12 months. It is recommended that you seek the advice of a professional accountant when using the straight line depreciation method in relation to tax deductibles. A professional will be able to advise you of all the requirements and implications in relation to depreciation and tax.
Other reasons for using straight line depreciation is that this method is uncomplicated, simple to apply and easy to understand. The same amount is taken out on your tax return every year, so there is no guesswork involved.
The disadvantage of straight line depreciation
A drawback of straight line depreciation is that machinery, office equipment, and other assets perform differently every year. Assets normally get less efficient when they get old and they may also need to be repaired. This loss of efficiency and the increase in repairs is not accounted for when using the straight line depreciation method. As a result, straight line depreciation is unsuitable for very expensive equipment. It is best to avoid using straight line depreciation when it is difficult to predict the useful life of an asset.
The straight line depreciation formula
The formula for straight line depreciation is as follows:
Straight Line Depreciation = (Purchase Price of Asset – Approximate Salvage Value) ÷ Estimated Useful Life of Asset
To calculate the straight line depreciation of your assets, you must:
- Take the acquisition cost or purchase price.
- Subtract the estimated salvage value when it is sold, retired or disposed of.
- Divide the number by the total amount of years the asset can reasonably be expected to benefit your business.
Straight line depreciation examples
You want to buy a new computer for your business, which costs $5,000. You predict that at the end of your hardware’s useful life, there will be $200 in salvage value for some parts, which you will sell to get back some of the original money you spent.
You normally upgrade your computers every three years, so you allocate three years as the estimate of useful life. The straight line depreciation can be calculated as follows for the above scenario:
- (5,000 purchase price – $200 approximate salvage value) ÷ 3 years estimated useful life
- $4,800 ÷ 3
The answer is $1,600 annual straight-line depreciation expense.
Here is a breakdown of the above calculation in accounting terms, if you bought the computer for cash:
- $5,000 will be transferred to the property, plant and equipment line of the balance sheet from the cash and cash equivalents line of the balance sheet.
- The cash flow statement would show a $5,000 outflow for capital expenditures at the same time.
- $1,600 would be charged to the income statement every year for three years.
Each $1,600 charge will be balanced against a contra-account filed as plant, equipment, and property on the balance sheet. This decreases the asset’s carrying value.
When the three years have ended, $200 will represent the carrying value on the balance sheet. The depreciation expense will be finished for the straight line depreciation method and you can get rid of the asset. After this, the sale price will be included back into cash and cash equivalents. You must record any losses or gains that are more or less than the estimated salvage value. This means that there will not be a carrying value in your balance sheet’s fixed asset line.
Here is another straight line depreciation example:
If your business buys equipment for $10,000 and you have estimated that the useful life of this asset is eight years, with a salvage value of $2,000.
In the above example, the straight line depreciation will be calculated as follows:
- The cost of the asset = $10,000.
- The asset’s salvage Value = $2,000.
- Total Depreciation Cost = Cost of asset – Salvage Value = 10000 – 2000 = $8000
- Useful life of the asset = 8 years
The annual depreciation cost is (Cost of asset – Salvage Cost)/Useful Life = 8000/8 = $1000).
Therefore, the equipment you have bought for your business will depreciate by $1000 each year, for eight years.
You can also work out the depreciation rate, taking into account the annual depreciation amount and the total depreciation amount which is annual depreciation amount/total depreciation amount.
This means that the depreciation rate is = (annual depreciation amount/total depreciation amount)*100 = (1000/8000)*100 = 12.5%.
For the above example, the depreciation on the balance sheet for the eight years will be:
|Year||Book Value (beginning year)||Depreciation||Book Value (end year)|
To change the depreciation charge on the balance sheet for the above example, you will need to do the following:
- The cash and cash equivalent are reduced by $1,000 (the cost of the equipment) and transferred to the property, plant and equipment line of the balance sheet.
- During the same time, the cash flow statement will show an outflow of $1,000.
- The $1,000 will be transferred to the income statement as a depreciation statement for eight consecutive years.
- The sum of $1,000 will be added to the contra-account of the balance sheet every year.
- When the equipment is at the end of its useful life, its carrying value will be $2,000. If you sell the equipment for more than the salvage value, you have to record a profit in the income statement. However, if you sell the equipment at the end of its useful life for less than the salvage value, you will need to record this as a loss.
- The cash inflow in the cash flow statement will show the amount that you made after selling the asset.
Straight line depreciation calculator
Consider using a straight line depreciation calculator if you want a quick way to find out how much your assets will depreciate on an annual basis.
- The cost.
- The salvage value.
- The useful life.
- The years.
Invest in your business
Working out the straight line depreciation of your assets is not only simple but it also provides your business with more certainty in relation to financial reporting.
Employee wages is another area where accurate financial reporting is highly beneficial to business owners. The amount you spend on payroll can vary when you employ hourly workers. Deputy integrates with most payroll systems to ensure that your employees receive the right amount of pay for the hours they have worked. Contact us for a demo to find out how Deputy can remove uncertainty from paying your hourly employees.
The information contained in this article is general in nature and you should consider whether the information is appropriate to your needs. Legal and other matters referred to in this article are of a general nature only and are based on Deputy's interpretation of laws existing at the time and should not be relied on in place of professional advice. Deputy is not responsible for the content of any site owned by a third party that may be linked to this article and no warranty is made by us concerning the suitability, accuracy or timeliness of the content of any site that may be linked to this article. Deputy disclaims all liability (except for any liability which by law cannot be excluded) for any error, inaccuracy, or omission from the information contained in this article and any loss or damage suffered by any person directly or indirectly through relying on this information.