Owning a business requires constantly monitoring a variety of assets. Some assets wear out over the years and begin losing their value; for example, computers, tools, equipment, vehicles and buildings can depreciate over time and must be repaired or replaced. In order for a business to accurately write off these expenses and file their taxes correctly, you need to calculate their amount of deprecation.
Continue reading to find out more about the well-known straight line depreciation method, how it's calculated, and how it can help a business.
The Basics of Straight Line Depreciation
Straight line depreciation is one of the most popular and simple methods for calculating how much an asset loses value over time. Using the straight line method, you will assume one constant rate of depreciation for any specific asset. With that, you can calculate how much value that asset loses in one year and use that same figure for every subsequent year.1
The straight line depreciation is calculated using the asset's total purchase price, the scrap value, and the useful life, or the number of years it's estimated to last. You simply subtract the scrap value from the total purchase price and divide that total by the useful life amount to reach the annual depreciation for the asset. Once you have calculated this figure, subtract that amount each year from the asset value to find its current value or book value.
Calculating the annual depreciation of an asset using the straight line depreciation method requires a simple math problem. As mentioned earlier, you will need three figures to calculate: total purchase price, scrap value, and useful life. Plug in those numbers to the following formula to find the current book value or annual depreciation: purchase price - scrap value / useful life.
An example of this formula may be the purchase of a new computer for a business. The purchase price of the device is $1,500 and the scrap value estimate is $500. According to the IRS, the useful life is five years. . Using the formula above you would calculate the annual deprecation like this: $1,500 - $500 = $1,000 / 5 years = $200.
The straight line depreciation method calculates the computer will depreciate $200 every year.
How Is It Different from Other Methods of Depreciation?
The straight line method of depreciation maintains its “straight line” by keeping the same figure from year to year. The assets will depreciate annually, but the figure used will remain the same. Other methods such as the sum of years, double-declining balance, or unit-of-production adjust their figures each year.
The sum of years and double-declining balance methods both place a higher depreciation rate at the start of an asset’s life and then decline each year after. These methods can be more accurate when dealing with items such as computers or vehicles, since those tend to lose the most value within the first few years of use.
The unit-of-production method measures depreciation by units instead of dollar amounts. This method would be used if calculating things such as the mileage of a vehicle or pages printed from a printer. This equipment type loses value based on the amount it is used instead of the years it has been in service. To calculate the depreciation, subtract the scrap value from the purchase price and, instead of dividing by the years of life, multiply by the number of units produced. Then, you divide by the number of units expected for its lifespan. This unit-of-production method works best when used with assets that are rated by the number of specific items they produce and not the amount of time they are used.
When is the Straight Line Method of Depreciation Used?
To understand the true value of a business, including all of its assets, you need to have an accurate calculation of depreciation. If a business is trying to determine their overall profitability, they may create an income statement that includes a current figure on the depreciation of assets. Depreciation would also need to be calculated when creating a balance sheet to show how the business is doing as a whole. Businesses that own many costly assets with a long useful life will find the straight line depreciation method helpful.
Another time this method of calculating depreciation comes into play is during tax preparation. The IRS allows for depreciation to be a write-off, and in some cases, the full cost of an asset is deductible. The IRS has a list of the useful life figures for most assets that they have sorted into different groups ranging from three to 25 years’ worth of use.2 Some businesses choose to use the sum of years or double declining balance methods for taxes since the deductions are higher at the beginning of the asset’s life.
What Value Does This Formula Bring to a Business?
The straight line depreciation method helps a business maintain an accurate figure of their assets' current value. By calculating the depreciation value each month, you can see both that month’s regular expenses and how much depreciation has accumulated.
The depreciation expenses could be tallied as an expense and put in the business’s income statement for that month. The same amount would then be put under accumulated depreciation as a credit. This will help a business to cumulatively see how much they are writing off through their depreciating assets. Using the same figure year after year keeps the bookwork simple and enables the quick calculation of expenses and deductions.
Why Use the Straight Line Depreciation Method?
Businesses have an endless amount of expenses and revenue to keep track of on a day-to-day basis. Learning and using this simple formula can help reduce tax obligations, improve accounting methods, and make it easier to see current business value. The reliability and consistency of the formula also helps to streamline processes and simplify an accountant’s work, even if they’re unfamiliar with the company and its previous tax reports.
Earn a Master’s That Goes Beyond the Basics
When you’re interviewing for accounting roles, employers will expect you to understand common business terms and formulas like straight line depreciation. What will set you apart, however, is an ability to bridge accounting theories with real-time business practice, working well with various teams, and considering the human impact behind your work. If you want those standout skills for your job search, you should consider an online master’s in accounting degree from Yeshiva University's Sy Syms School of Business.