Straight Line Depreciation
In simple terms, Depreciation is the reduction in the selling value of a product over time. The value reduces over time due to wear and tear of the product as it is used. This applies to mostly fixed assets such as machinery, furniture, electronic devices, cars etc. It does not include land or property as in most cases, they gain value over time.
You might want to check The Key to Managing Finances: Profit and Loss Statements
What is Straight Line Depreciation?
Straight line depreciation is a method to calculate the value of a fixed asset over a certain period of time. The value reduces by the same amount each year until the end of its useful life. A few key terms that we have to acquaint ourselves with are:
- Asset Cost: The total price of the asset including delivery fees, packaging etc.
- Useful Life: The estimated life span of an asset generally measured in years.
- Salvage Value: The asset’s value at the end of its useful life.
When as asset reaches the end of its useful life or is fully depreciated. It doesn’t mean the asset is obsolete. Businesses can still use the asset as long as it is functional. The added benefit being they no longer have to report an expense.
How to Calculate Useful Life
If an asset has a useful life more than one year, it is generally depreciated. These are a few examples of the useful lifespans as estimated by the IRS:
– Five Years – cars, trucks, office machinery, computers
– Seven Years – office furniture, agricultural equipment
These estimates reflect the time these assets are useful to a business not how long they will last.
How to Calculate Salvage Value
The salvage value estimates how much an asset is worth after the ned of its useful life. Two things to consider are how long you intend to use the asset and how much it is used.
Generally, if a business plans to use a cheap asset for a long time, then the salvage value is typically zero. For assets being sold before the end of their useful life, the salvage value is greater than estimated.
Algorithm for Straight Line Depreciation Calculation
- The asset cost and salvage value are approximated
- The total depreciable amount is calculated by taking the difference of the asset cost and the salvage value
- The estimated useful life is found (which varies from asset to asset)
- The annual cost of depreciation is calculated by dividing the total depreciable amount by the useful life
- The straight line depreciation rate is found out by dividing the annual cost of depreciation by the total depreciable amount
Total depreciable amount= (Asset Cost – Salvage Value)
The annual cost of depreciation = Total Depreciable Amount / (Useful life of the asset)
Straight Line Depreciation Rate= Annual Cost of Depreciation / Total Depreciable Amount
A company decides to purchase some new machines. A machine is bought for around $150,000 which includes the shipping charges as well as the taxes involved. The company decides to use the machine for 4 years after which they plan to sell it for an approximated sum of $50,000 to other buyers.
Calculate the straight line depreciation rate for this machine.
1. The asset cost= $150,000
2. Total depreciable amount= (Asset Cost – Salvage Value)
= ($150,000 – $50,0000)
3. Useful life of asset= 4 years
4. The annual cost of depreciation = Total Depreciable Amount / (Useful life of the asset)
5. Straight Line Depreciation Rate= Annual Cost of Depreciation / Total Depreciable Amount
= $25,000 / $100,000
=0.25 or 25%
|Year||The amount at Start of the Year||The amount at the end of the year|
This example illustrate using the figure shown above.
- The straight line in orange indicates the value of the machine at the start of the year
- The straight line in red indicates the value of the machine at the end of the year.
- The difference between the two straight lines at any given year is the amount depreciated annually which is a constant
- The salvage value is the value of the red line on Year 4 or the least point on the graph
- The asset cost is the value of the orange line at Year 1 or the peak value of the graph
- The salvage time is the number of years on the horizontal axis
Importance of Straight Line Depreciation
Straight line depreciation allows businesses to utilize the use of an asset over a period of time. This reduces the net income for each period instead of one large expense. The straight line depreciation method ensures assets are accurately accounted for in financial statements of a business.
In conclusion, businesses need to show their expenses and incomes to the authorities such as IRS. This method is not ideal as there are a lot of assumptions mostly that the prices of assets go down rate a uniform rate. This does not factor in inflation and any financial break downs.
The method ignores the wages of the employees, the number of employees using the asset, the run time, maintenance cost of the asset, any accidental damages and insurance premiums associated with the asset in question. Despite all the shortcomings, the straight line depreciation method is widely used by a business due to its simplicity, ease of evaluating a company’s assets and financial reporting.