Straight Line Depreciation
Businesses often require some physical assets that help with revenue generation. After some time, these tangible assets begin to wear out or cease to function. To know how a business is truly performing, it needs an authentic accounting report. And to record a conclusive accounting report, an organization needs to value the physical assets taking into account any drop in asset value. Straight line depreciation is one of the methods that companies can use to calculate depreciation. Read on to find out insightful details on this depreciation method, differences with other models, pros and cons, how to calculate the depreciation, and a practical example to crown it all.
What Is Straight Line Depreciation in Accounting?
This type of depreciation method defines the uniform depreciation of the value of an asset. To apply the straight line depreciation model, also known as the fixed instalment method, accountants will deduct a similar amount of depreciation from the asset’s value every year of its useful life up to its salvage value.
At this point, the firm can try to sell off the asset or write it off to recoup any residual value. The method allows businesses to allocate the cost of an asset basing it on its depreciated value.
Companies typically use this technique to determine the monetary value of a specific asset throughout its lifetime. So now that we know what is straight line depreciation, let’s proceed to more invaluable information about this accounting formula. Below is a pictorial representation of straight line depreciation:
Image source https://corporatefinanceinstitute.com/
How Is Straight-line Depreciation Different from Other Methods?
When determining the shift in value in company assets, cccountants have five depreciation methods to choose from. Most of these methods typically accelerate the depreciation of an asset while straight line depreciation maintains a constant decline value. Take a brief look at the other ways to see how they compare with the straight line option. A business should use the depreciation model that best matches the asset in question:
- Declining Balance Method – the method accelerates the loss in value of an asset faster than the straight line depreciation model. The technique works on the principle of applying the yearly depreciation percentage of an asset to its decreasing value the following year. It results in faster asset depreciation in its first year of use and slower depreciation after years of service.
- Sums-Of-Years-Digits Methods – it is an accelerated method that takes advantage of a complex fraction that you determine by the total number of years in the depreciation schedule. In this case, an accountant can use the useful lifespan of an asset to come up with the common denominator, which they will then divide into each year. They finish by multiplying the result by the difference between the asset’s initial and salvage values. It is a complex method that can bring out multiple calculation errors.
- Double-Declining Balance Method – it is a method that is almost similar to the declining balance depreciation model. The only difference is that it doubles the percentage of the yearly depreciation often determined by predicted by schedule and salvage value. It simply implies that the depreciation rate will be twice as high when compared with the straight line depreciation model.
- Units of Production Method – this is another method that accountants can use instead of the straight line depreciation model. You estimate the number of units the tangible asset will use in a financial year when using this method. It is the figure that accountants use to calculate depreciation value. It relies on estimates similar to the straight line option but pays more attention to the assets’ revenue to the business.
Advantages and Disadvantages of Straight Line Basis
Using the straight line depreciation method comes with its pros and cons. Check out some of the advantages and disadvantages of the straight line technique:
Simplicity – one of the perks of straight line depreciation is it’s a very simple model. Anyone can use this method with ease because calculations are not complicated. The process uses minimal useful variables, such as lifespan, salvage value, and purchase price, making it ideal for small and established businesses.
- Freedom – with this model, a company can name the desired depreciation schedule of an asset and its salvage value.
- Total depreciation charge is made available – it is possible to know the depreciation amount by calculating the total number of years an asset is still useful by the yearly amount of depreciation.
- Excellent for assets of lesser value – the model works well for calculating depreciation charges on lesser value assets such as fixtures and furniture.
- Assets can be completely written off – with straight line depreciation; companies can write off assets completely. It is because depreciation using this model results from the original cost of an asset (at a constant rate). It implies that the asset’s value is spread out equally over its use time.
- Tax purposes – straight line depreciation allows businesses to calculate the depreciation rate of assets which they can list in financial documents such as profit and loss statements and balance sheets. A company can claim the valuation changes as depreciation expenses which can lower income tax.
- – It doesn’t account for the loss of efficiency – as assets age, they become less efficient increasing repair and maintenance costs. Because straight line depreciation is equal for all years, it does not account for efficiency loss or increase in repair expenses. It implies that the method may not be the best for expensive assets like plants.
- – It does not include replacement provisions – no provision for asset replacement is available when using this method. A business will retain the depreciation charge and use this to perform regular affairs. The organization must raise funds for replacing assets when it’s time.
- – Loss of interest – another drawback of the straight line depreciation model is a firm does not receive any interest because the company does not invest any of the assets depreciation charges outside the firm.
- – Potentially low accuracy – because straight line depreciation works off a rough estimate of depreciation schedule and salvage value, it may lead to potentially inaccurate figures and less nuance.
When Should I Use the Straight-line Method?
There are several scenarios where it’s best to use the straight line method of depreciation, and these include:
I.When it’s impossible to gauge the specific pattern in which a tangible asset depreciates.
II.For calculating tax deductions. After business purchases a fixed asset like a computer, vehicle, or furniture, it’s not possible to write off the entire amount in the first year. Instead, it is best to spread the whole amount across the period when the firm uses the asset for the business.
III.For accounting purposes, a business can record depreciation in its financial books to accurately reflect its performance. Keep in mind that you should calculate depreciation as an expense. In most cases, this type of depreciation will appear on an adjusted trial balance as a fixed cost. You will always add this to an operating cash flow balance because depreciation is an operating cash expense that directly affects working capital.
IV. To determine the value of a business. Straight line depreciation also allows entrepreneurs to get a good grasp of an organization’s total assets.
How Do You Calculate Straight Line Depreciation?
Calculating straight line depreciation is a straightforward process. Here are the steps to follow when you want to learn how to do straight line depreciation:
- Determine the initial cost of the asset.
- Subtract the residual value of the asset from its original price. This step is crucial for arriving at the total depreciable amount.
- Determine how long you will use the asset.
- Finish by dividing the total depreciable amount by the asset’s useful life to get the yearly depreciation amount.
The straight line depreciation formula to use is:
Cost of the asset- expected residual value = Straight line depreciation for the period
Example of Straight Line Depreciation
To put the above calculation formula into practice, here is an example of how the straight line method works. Say a bakery purchases an oven that costs $40,000 and its useful life is ten years, and the residual value is $1000. Here is how to calculate depreciation using straight line method:
The depreciable amount of the oven is $39,000 (40,000-1000). The depreciation calculations annually will take into account the number of years the asset will be in use as follows will be:
Yearly depreciation= $39,000/10 = $3,900 annually.
The depreciation charge on the oven will be $3,900 annually for ten years.
Straight line depreciation is an accounting method that many businesses can benefit from when realizing an asset’s value loss over time. Compared to other depreciation methods, it is one of the simplest to use, the reason many accountants prefer to use the technique with valuable tangible assets in the business. It is not only simple to use, but it is also susceptible to fewer errors over an asset’s lifetime. Accountants also appreciate that the method expenses a similar amount for each accounting period making it easier to keep business records.