Depreciation is the process of determining how much a tangible asset has decreased in value over time. Essentially, a tangible asset is a piece of physical property with economic value. There are multiple methods of calculating depreciation, including straight-line and accelerated methods. Knowing which method works best for your business is crucial.
Here we will talk about straight-line depreciation and how to calculate it.
What Is Straight Line Depreciation?
The value of an asset is reduced by a fixed amount of depreciation every year. And the straight-line method of depreciation is used to depreciate assets until they reach salvage (scrap) value.
Depreciation using the straight-line method can be calculated using the following formula:
Annual Depreciation Expense = (Original Cost – Salvage Value ) ÷ Useful Life.
- The original cost: the price you paid for the asset as well as any extra fees you paid, such as sales tax, shipping, and handling charges.
- Salvage value: a salvage value is how much you predict the asset will be worth after its useful life has ended.
- Useful Life: The period of time during which the asset can be used.
Equipment, machinery, and buildings are examples of fixed assets that are expected to last for several years or longer. Depreciation smooths out the costs of these items over time since they are typically high-cost items. Doing this allows a company’s financial statements to avoid cash balances and profitability swings if all expenses occur simultaneously. Since the asset’s usefulness constantly declines from period to period, the straight-line method is the most simple method for calculating depreciation.
The depreciation expense account must increase on the income statement, while the accumulated depreciation account must increase on the balance sheet for straight-line depreciation.
How Do You Calculate Straight Line Basis?
Depreciation on assets using the straight-line method is calculated by using the following steps:
- Step 1. Find out how much the asset is worth. Usually, it is the historical cost or value of an asset that appears on a balance sheet.
- Step 2. Find out what the asset’s salvage value is. Essentially, it is the asset’s estimated worth at the end of its lifespan. The valuer will determine this value and represent the minimum amount the seller can obtain at the end of its useful life.
- Step 3. Find out how long the asset will last. A registered valuer also determines it. Asset life refers to how long the asset can generate revenue for the organization.
- Step 4. By applying the formula below, you can calculate depreciation:
Annual Depreciation Expense = (Original Cost – Salvage Value ) ÷ Estimated Useful Life.
Example of Straight Line Depreciation for an Ecommerce Business
Let’s say you own a small Ecommerce business for which you decide you need a $5,000 cost computer server. You estimate that the hardware parts will be worth $200 (salvage value) when they reach the end of their useful life.
Previously, your company upgraded its hardware every three years despite accounting rules allowing computers to last for five years at most. In your opinion, three years is a more realistic estimate of the computer’s useful life since you will probably dispose of it at that point.
Here is how you can calculate straight-line depreciation using this information:
Step 1: $5,000 purchase price – $200 approximate salvage value = $4,800
Step 2: $4,800 ÷ 3 years estimated useful life = $1,600
Annual straight-line depreciation expense: $1,600
Example of Straight Line Depreciation for a Digital Agency
Let’s say a digital marketing agency XYZ has just invested $1 million into long-term fixed assets.
The fixed assets will have a useful life of 20 years, and their salvage value will be zero at the end of their useful life, based on management’s estimate.
Initially, we calculate the numerator by subtracting the purchase cost from the salvage value. However, since the salvage value is zero, the numerator equals the purchase price.
Step 1: $1 million purchase price – 0 salvage value = $1 million
Step 2: $1 million ÷ 20-year useful life = $50k
Annual straight-line depreciation expense: $50k
Pros and Cons of Straight Line Basis
The following are the pros of using the straight-line method when calculating depreciation:
- It is the easiest and most convenient method for calculating an asset’s depreciation.
- By applying the straight-line method, it is possible to reduce an asset’s value to zero or net scrap.
- Adding the yearly depreciation to the number of years the asset will be in use makes it easy to calculate the total expense.
- Depreciation amounts are uniform. The profit and loss account is reduced by this amount every year.
- Smaller businesses can benefit from this method.
- Because depreciation amounts are the same every year, profits can be compared more easily between years.
- Calculating depreciation this way can be useful for determining the life expectancy of assets in regular use.
There are a few cons to using the straight-line method to calculate depreciation:
- Rather than relying on estimates, this approach relies more on guesswork. For example, if there are rapid technological improvements, the asset would depreciate more quickly than expected. If the asset’s value declines yearly, it is not reasonable to depreciate it at its original cost.
- Furthermore, this method excludes short-term losses in asset value. Throughout its life, the asset incurs more repair and maintenance costs. Since depreciation is equal every year, it puts undue stress on the asset.
- This method does not work well when it comes to assets like machinery, plants, or buildings that are prone to expansion or addition. In short, it is not suitable for organizations with a large number of assets.
Final Thoughts on Straight Line
The straight-line depreciation method is the most straightforward way to calculate an asset’s value loss over time. Using this method, you can spread the cost of an asset evenly over its useful life, which is helpful in bookkeeping. Small business owners can easily and simply depreciate their assets with the straight-line method. However, when setting up your small business accounting system, take the time to choose the right depreciation method based on your fixed asset usage pattern.