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Straight Line Depreciation: How Does It Work?

Straight Line Depreciation: How Does It Work?

Straight Line Depreciation

All assets depreciate over time. Therefore, whenever you buy any asset for your business, like new buildings, machines, or computers, it will depreciate over time. After it depreciates over its useful life, it’s sold off at the final remaining value – its salvage value. Here, the easiest way to calculate depreciation is the straight line depreciation method.

If you wish to know in-depth information on this form of depreciation and how to calculate it, read this post till the end!

What Is Straight Line Depreciation?

What Is Straight Line Depreciation_

Straight line depreciation is one of the most commonly used methods for calculating depreciation. In this method, it’s estimated that the value of an asset depreciates by the same amount every year throughout its useful life span. Therefore, its value depreciates by the same amount every year until it reaches its salvage value.

This depreciation value is used for calculating the net operating income of the firm.

When To Use Straight Line Depreciation?

Straight line depreciation is best used on assets that depreciate automatically over time by the same amount. Therefore, this method is best used on assets that remain stationary throughout and depreciate slowly over time for many years. Typically, this method is best used for assets like furniture, warehouses, buildings, etc., which depreciate by the same amount annually.

How To Calculate Straight Line Depreciation?

How To Calculate Straight Line Depreciation_

In this method, the salvage value of an asset is estimated when the asset is bought. Here, an appraiser is hired to apprise the asset so that its final salvage value after its useful lifespan can be calculated.

Therefore, now that the final salvage value of the asset gets calculated, it now becomes easier to calculate depreciation. All you have to do is subtract the salvage value from the initial book value of the asset. Here’s the straight line depreciation formula to calculate accumulated depreciation:

Annual Depreciation = (Asset Value – Salvage Value) / Useful Life In Years

Here’s an example of this depreciation equation in action:

Let’s suppose you buy a laptop for $2000. This laptop is expected to be useful for four years. After appreciating it, its salvage value (at the end of the fourth year) is estimated to be $500. Therefore, the depreciation will be = ($2000 – $500) / 4 = $375

Benefits And Drawbacks Of Straight Line Depreciation

Benefits And Drawbacks Of Straight Line Depreciation

Using straight line depreciation has many benefits and drawbacks.

Pros

The advantages of straight line method depreciation are:

  • Straight line depreciation is pretty easy to calculate since the calculations are simple and require easy-to-attain values for calculation.
  • This form of depreciation can be used to calculate depreciation for various fixed assets, which depreciate over time automatically.
  • It’s easier to schedule depreciation using the straight line method, which helps in reducing the overall amount required for bookkeeping.

Cons

The main disadvantages of straight line depreciation are:

  • There are many assets that are depreciated better off on their output, making the units of depreciation method more viable.
  • Some additional calculations are necessary after calculating using this depreciation equation. This is because for calculating tax as per USA Tax Guidelines, MACRS recovery periods should be included.
  • Many assets like vehicles and computers depreciate faster earlier and slowly later on. This is where the sum-of-the-years digits method is more viable.
  • The salvage amount set by the appreciator is inconsistent since different asset appreciators will give different salvage values.

Other Depreciation Calculation Methods

Apart from straight line depreciation, there are various other methods to calculate depreciation. Here, the most widely acknowledged depreciation methods as per the GAAP (Generally Accepted Accounting Principles) are:

1. Declining Balance Method

Declining Balance Method

As per this method, your assets depreciate at a fixed rate (depreciation percentage) every year. Therefore, since the same rate of depreciation is taken into account, the amount of depreciation declines every year. However, the salvage value of the asset is subtracted from the net book value of the asset every year for calculation.

Here’s the formula:

Declining Balance Method Depreciation = (Net Book Value – Salvage Value) x Rate of Depreciation

Here’s how this formula is applied:

Let’s suppose you buy a laptop for $2000. This laptop is expected to be useful for four years. After appreciating it, its salvage value (at the end of the fourth year) is estimated to be $500, and it would depreciate by 20% every year. Therefore, the depreciation on Year 1 would be = ($2000 – $500) x 20% = $300. Similarly, the depreciation for Year 2 would be = ($1500 – $300) x 20% = $240.

2. Double Declining Balance Method

Double Declining Balance Method

The double declining balance method (also known as accelerated depreciation) is similar to the straight-line depreciation and declining balance methods. However, the only difference here is that the rate of depreciation is doubled here. The rate is kept the same across all useful years of the asset.

For the sake of simplicity, the rate of depreciation is twice 100%, which is divided by its useful life in years. Here’s the formula, divided into three steps:

Double Declining Balance Method Rate = (100% / Useful life in years) x 2 Depreciable Base = Initial Amount – Salvage Value (for Year 1) Double Declining Balance Method Depreciation = Depreciable Base x Double Declining Balance Method Rate

Here’s how this formula is applied:

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Let’s suppose you buy a laptop for $2000. This laptop is expected to be useful for four years. After appreciating it, its salvage value is estimated to be $500. Therefore, its double declining depreciation rate is 25% (100% depreciation / 4 years). Also, its depreciable base for Year 1 is $1500 (Initial price – salvage value). So, its double declining balance method rate will be 50%. Therefore, its depreciation amount in Year 1 would be = $1500 x 50% = $750. For Year 2, this would be = ($2000 – $750) x 50% = $625.

3. Sum-Of-The-Years Digits Method

Sum-Of-The-Years Digits Method

In this depreciation method, most of the depreciation is recorded at the start. Therefore, as it nears the end of its useful life, the depreciation recorded gets lower and lower. This calculation is done by adding up the digits of the useful years and then depreciating accordingly.

Therefore, the formula here is:

Annual Depreciation = Depreciable Base x (Inverse Number of years/sum of year digits)

Here’s an example of how this works:

Let’s suppose you buy a laptop for $2000. This laptop is expected to be useful for four years. So, the sum of year digits will be 4+3+2+1 = 10. Therefore, for Year 1, its depreciation will be = $2000 x (4/10) = $800. For Year 2, it will be = $1200 x (3/10) = $360.

4. Units Of Production Method

Units Of Production Method

In this depreciation method, the total output produced by the asset is considered. After that, the output consumed annually is then recognized.

Its formula is:

Annual Depreciation = (Number of consumed output / total units to be produced) x Depreciable Base

Here’s an example:

Let’s suppose you buy a laptop for $2000. This laptop is expected to be used for 8000 hours overall. In the first year, you used it for 2000 hours. Therefore, its Year 1 depreciation would be = (2000/8000) x $2000 = $500. For Year 2, if the same amount of hours is used (2000 hours), then it will be = (2000/8000) x $1500 = $375.

Conclusion

Calculating depreciation using the straight line depreciation method is simple as long as you know the useful life of the asset and its salvage value at the end of its useful life. This makes this form of depreciation calculation better suited for assets like furniture, buildings, etc – since they depreciate slowly by the same amount over a long time.

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