Straight-Line Depreciation
Straight line depreciation is a depreciation method that stays constant over the useful life of a fixed asset.
What is Straight Line Depreciation?
Straight-line depreciation is the simplest depreciation method whereby a company reduces a fixed asset’s book value by the same amount every period over its useful life until it reaches its salvage value. The reduction in value is referred to as depreciation expense. Depreciation is the process of allocating the cost of an asset over its useful life. It is the technique a company uses to track the decreasing value of aging assets.
Depreciation is recorded in accordance with the matching principle of Generally Accepted Accounting Principles (GAAP). The matching principle requires that expenses are matched to the revenues they generate in the same accounting period. Since the fixed asset provides a benefit to the business and allows it to continue generating revenue over its useful life, its cost must be allocated over the same time period.
Where Does Depreciation Appear on the Financial Statements
Depreciation expense appears on a company’s income statement. The income statement shows all revenue and expenses that have been generated and incurred in the given accounting period. Accumulated depreciation, on the other hand, appears on the balance sheet. It is the sum total of all depreciation expense taken on the company’s fixed assets to date. The balance sheet shows assets, liabilities, and equity in a business as of a given date– the end of a given accounting period. The information on a balance sheet rolls over from period to period as the value of these accounts change over time.
Straight Line Depreciation Formula
The formula for straight line depreciation is:
Annual Depreciation Expense = (Original Asset Cost - Salvage Value) / Useful Life
Original Asset Cost
The original cost of the asset is its purchase price plus any other costs incurred to make it ready for use. Other costs that may be included in the original cost of an asset include:
- Transportation & Installation Costs
- Commission Fees
- Taxes
All fixed assets are initially recorded on a company’s books at this original cost.
Salvage Value
An asset’s salvage value is the amount that remains on a company’s books after the asset is fully depreciated. A fixed asset may have a salvage value because the company plans to resell the asset when it is done with it.
Useful Life
An asset’s useful life is the length of time over which a company expects the asset to continue to remain useful– to provide a benefit to the business. It is the length of time over which an asset is depreciated because the expense from the asset must tie to the revenue generated by the asset in the same period per the matching principle.
Example of Straight Line Depreciation
ABC Construction Company is a small family owned construction business. They purchased a small excavator for $60,000– including all taxes and fees. ABC Construction Company plans to use straight line depreciation. The useful life of the excavator is 10 years, and its salvage value is estimated to be $10,000. Using this information, we can calculate the annual depreciation expense to be:
$5,000 = ($60,000 - $10,000) / 10
Where:
- $5,000 = annual depreciation expense
- $60,000 = original cost of excavator
- $10,000 = salvage value of excavator
- 10 = Number of years in excavator’s useful life
Other Methods of Depreciation
There are other methods of depreciation that a company can use. Here are the three most common alternatives:
- Double declining balance (accelerated depreciation method)
- Sum-of-the-years’ digits (accelerated depreciation method)
- Units of output method (based on usage of the fixed asset)
An accelerated depreciation method takes the bulk of the depreciation expense in the first few years and a lower rate of depreciation in the final few years of the asset’s useful life.
Double Declining Balance Method
The double declining balance method multiplies twice the straight line depreciation percentage per year by the beginning book value of an asset to calculate the period’s depreciation expense. It does not back out the salvage value in the original calculation, so care must be taken to not depreciate the asset beyond its salvage value in the final year.
The total accumulated depreciation at the end of the asset's useful life will be the same as an asset depreciated under the straight line method. However, an asset depreciated using the double declining balance method will have depreciation expense taken over a smaller number of years than one depreciated using straight line depreciation.
Here is how to calculate the annual depreciation expense using double declining balance.
Annual Depreciation Expense = 2 x Straight Line Depreciation Percentage x Beginning Book Value
Where:
- Straight line depreciation percentage = percentage of total depreciation booked in each year under the straight line method
- Beginning book value = book value at the beginning of the period for which depreciation expense is being calculated
Using the ABC Construction Company example from above, you could calculate the first year double declining balance depreciation expense as:
$12,000 = 2 x 10% x $60,000
Where:
- $12,000 = annual depreciation expense
- 10% = $5,000 annual depreciation expense using straight line / $50,000 total depreciation
- $60,000 = beginning book value in first period
Note, the beginning book value in the second period is $48,000.
$48,000 = $60,000 - $12,000
Where:
- $48,000 = beginning book value for second period
- $60,000 = beginning book value for first period
- $12,000 = annual depreciation expense in first period
Sum-of-the-Years’ Digits Method
The sum-of-the-years’ digits method is calculated by multiplying a fraction by the asset’s depreciable base– the original cost minus salvage value– in each year. The fraction uses the sum of all years in the useful life as the denominator. The first year starts with the largest digit in the numerator. Each year the numerator decreases by 1.
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For example, a company that owns an asset with a useful life of ten years will multiply the depreciable base by 10/55 in year 1, 9/55 in year 2, 8/55 in year 3, 7/55 in year 4, 6/55 in year 5, 5/55 in year 6, 4/55 in year 7, 3/55 in year 8, 2/55 in year 9, and 1/55 in year 10.
Where:
- Sum of Years’ Digits = 10+9+8+7+6+5+4+3+2+1 = 55
- Largest Digit (Year 1) = 10
Calculating the same ABC Construction depreciation expense using sum-of-the-years’ digits in the first year, we have:
$9,090.91 = 10/55 x $50,000
Where:
$9,090.91 = annual depreciation expense
10/55 = first year fraction for 10 year useful life
$50,000 = $60,000 - $10,000 = depreciable base or total depreciation over useful life
Units of Output Method
The units of output method is based on an asset’s consumption of something measurable. It is most likely to be used when tracking machine hours on a machine that has a finite and quantifiable number of machine hours. Since it is based on consumption, it could fluctuate each year. The depreciation expense calculated by the straight line depreciation method may, therefore, be greater or less than the units of output method in any given year.
Advantages and Disadvantages of Straight Line Depreciation
Straight line depreciation is the simplest method of depreciation. Its simplicity to calculate and understand is its greatest advantage. The smooth and even depreciation expenses each period are easy to forecast into the future. If you have a small business and do not want to work through complicated depreciation formulas, the straight line depreciation method is a great option. It is always allowed by GAAP.
Straight line depreciation loses some of its appeal when it is applied to high dollar value assets that may depreciate at an uneven rate. For example, when you drive a new vehicle off the lot, it loses most of its value in the first few years. The depreciation rate slows as the asset ages. An even application of depreciation expense is not appropriate in this circumstance. Straight line depreciation is also not ideal for assets that may have multiple additions or expansions in the future– such as buildings and machinery.
Additional Resources
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