In the, the value of fixed assets is reduced over its useful life.
With this method, the depreciation value remains constant over the asset’s useful life because it is assumed that the assets continue to provide the same level of benefit to the company throughout their useful life.
Straight line depreciation is determined by dividing the difference between an asset’s purchase price and its anticipated salvage value by the number of years it is expected to be in use.
Businesses use amortization for intangible assets such as patents and software and depreciation for physical assets. Both methods spread the cost of an asset over its useful life, helping the company avoid a significant one-time expense that could decrease its income and profitability if the entire cost of the asset were expensed in the year it was purchased.
Why does business prefer the Straight-line Depreciation method?
Small businesses prefer to use the straight-line depreciation method, as this helps them free up cash flows for investment, improve overall financial planning, reduce the risk of unexpected tax bills, and plan for future tax liabilities.
Some of the other reasons to choose the straight-line depreciation method are mentioned below:
Tax Benefits: The straight-line depreciation method considers depreciation expense a deductible expense, reducing taxable income and providing tax benefits to companies.
Investment Decision: Straight-line depreciation helps businesses improve their investment decisions. The business knows the annual depreciation amount, can calculate net income, and can determine whether the asset is a justified investment.
Simple: It is one of the easiest ways to calculate the depreciation expense as the depreciation amount remains over the asset’s useful life.
Compliance: The straight-line depreciation method is accepted under both IFRS (International Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles). Businesses can use this method to ensure compliance with these standards.
Predictable: The straight-line method offers a consistent depreciation expense over an asset’s useful life, making it easier for businesses to plan and budget for future asset replacement or maintenance needs.
How do you calculate the straight-line depreciation method?
Formula of Straight-line depreciation method
Straight-line depreciation = (Purchase Price of Asset – Salvage Value) / Estimated Useful Life of Asset
OR
Straight-line depreciation = (Purchase price of Asset – Salvage Value) x Depreciation Rate
where:
Purchase Price of Asset: It refers to the cost of the asset at which it is purchased. It includes the item price, and factors such as, transportation,commissions, warranties, appraisals and installation and testing.
Salvage Value: It refers to the value of a tangible asset at the end of its useful life.
Estimated Useful Life of Asset: It refers to the number of years the asset is expected to be used by the company.
Depreciation Rate: (Annual Depreciation Amount / Useful Life) x 100
Steps to calculate the straight-line depreciation method
Step 1: Find the cost of the asset. Make sure to include the price of the asset along with all the cost included while putting the service into use.
Step 2: Then, subtract the estimated salvage value from the cost of the asset to find the total depreciable amount.
Step 3: Next, determine the useful life of the asset.
Step 4: Finally, divide the depreciable amount by the useful life to calculate the annual depreciation amount.
Example of Straight Line Depreciation Method
Beauty & Beast Private Limited purchases a printer. The salvage value of the printer is $2,000 and its useful life is 4 years. Its purchase price is $20,000.
Solution:
Given:
Purchase price of the asset = $ 20,000
Estimated salvage value = $ 2000
Useful life of the asset = 4 years
Straight-line depreciation formula = (Purchase price of asset – Salvage Value)/Useful Life
After calculating the depreciation expense, the depreciation account on the balance sheet will show the accumulated depreciation for the printer over four years:
Year
Book Value (Beginning year)
DepreciationAmount
Book Value (End of the year)
1
$20,000
$4,500
$15,500
2
$15,500
$4,500
$11,000
3
$11,000
$4,500
$6,500
4
$6,500
$4,500
$2,000
Merits of Straight Line Depreciation Method
Appropriate for Small Businesses: This method is suitable for small and medium-sized businesses because it is easy and quick to calculate, and it does not require specific knowledge to implement.
Boosts timely asset replacement: By providing an estimated depreciation expense over the asset’s life, businesses can plan to replace depreciable assets at the end of their useful life in a timely manner.
Helps calculate Profits: Straight-line depreciation offers a consistent depreciation rate, which is valuable for comparing assets among different competitors or industries.
Demerits of Straight Line Depreciation Method
Not suitable for all assets: Some assets may depreciate more rapidly at the beginning or end of their useful life. This method works best for assets with a predictable and consistent decrease in value.
Loss of Revenue: The depreciation deducted is not reinvested or utilized outside the company, resulting in no additional revenue or interest for the business.
Unsuitable for large businesses: The straight-line method may not be suitable for large companies with different operations and various assets having different useful lives.
Conclusion
The straight-line depreciation method is a simple way to calculate the expense of any fixed asset in your business. Every business must know how to calculate straight-line depreciation of its fixed assets, as it is crucial to its success.
With straight-line depreciation, you can reduce the value of a tangible asset and get benefits from that depreciation during tax season.
