Depreciation is an accounting process that spreads the cost of a fixed asset, such asproperty and equipment, over the period of time it will likely be used. Doing so allowsa business to match expense recognition with the revenue those expenses support,ultimately resulting in a more accurate picture of its profitability. As such,depreciation is less about asset valuation and more about cost allocation. There aremany methods of depreciation that comply with Generally Accepted Accounting Principles(GAAP), though the most commonly used is the straight-line depreciation method, whichoffers the simplest, most straightforward way to calculate an asset's value overits time of use.
What Is Straight-Line Depreciation?
Straight-line depreciation spreads the cost of an asset evenly over the time it will beused, also known as its "useful life." It requires only three inputs tocalculate: asset cost, useful life and estimated salvage value — meaning, how muchthe asset is likely to be worth at the end of its useful life. Another important term tounderstand is "depreciable base," which is the difference between theasset's cost and its salvage value. The depreciable base is divided by the numberof years the asset is estimated to be useful, in order to calculate the annualdepreciation expense. In each accounting period, this depreciation amount is uniformlycharged, stepping down the asset's book value until it reaches its salvage value.
The chart below illustrates a typical straight-line depreciation scenario with aconsistent reduction in net book value — that is, an asset's carrying valueat a point in time — for a fixed asset over five accounting periods. (The chartuses the same figures as the free downloadable template found later in this article.)
Key Takeaways
- Straight-line depreciation is an accounting process that spreads the cost of a fixedasset over the period an organization expects to benefit from its use.
- Depreciation impacts a company's income statement, balance sheet, profitabilityand net assets, so it's important for it to be correct.
- The formula for straight-line accounting requires a mix of empirical data andreasonable estimates.
- Accounting software can reduce a company's burden of calculating andmaintaining individual depreciation schedules for each of its fixed assets.
Straight-Line Depreciation Explained
Fixed assets, such as machinery, buildings and equipment, are assets that are expected tolast more than one year, and usually several years. They are typically high-cost items,and depreciation is meant to smooth out their costs over the time they will be inservice. This helps to avoid wild swings in cash balances and profitability on acompany's financial statements that can be caused by expensing all at once.Straight-line depreciation is the simplest method for calculating depreciation becauseit assumes that the asset will decline in usefulness on a constant basis from period toperiod.
Bookkeeping for straight-line depreciation involves increasing the depreciation expenseaccount on the company's income statement and increasing accumulated depreciationon the balance sheet. Accumulated depreciation is a contra asset account — theaccount balance is actually a credit balance — so it indirectly reduces the bookvalue of a fixed asset when the asset and contra asset accounts are netted against eachother.
Why Is Straight-Line Depreciation Important?
Depreciation is important because, by matching expenses with revenue, a company'soverall profitability is determined more accurately. The straight-line method ofdepreciation, specifically, results in even, stable depreciation charges, so it makesbudgeting and financial forecasting easier. Additionally, the consistent charges assistoperating profitability and cash flow analysis, since they are easily identified andremoved.
Other Depreciation Methods
Besides straight line, accountants may use several other depreciationmethods. Activity-based methods, for example, yield variable depreciationcharges, since they are based on an asset's usage rather than on the passage oftime. Decreasing-charge methods accelerate the amount of depreciation in an asset'searly years, operating under the assumption that the asset experiences the largest lossof service value at the beginning of its useful life. Some examples of these alternatedepreciation methods include:
- Units-of-production method: This activity-based depreciation methodquantifies an asset's useful life in terms of the amount of output it isexpected to have. Depreciation charges are determined by the number of unitsproduced in a particular time period as a percentage of the units expected to beproduced over the entire useful life, which is then multiplied by the depreciablebase.
- Sum-of-the years'-digits method: This is an accelerateddepreciation method that results in lower depreciation charges in successive yearsby using a decreasing fraction of the depreciable base. The numerator in thefraction is the number of years left in an asset's useful life, and thedenominator is the sum of the years' digits. For example, the denominator foran asset with a five-year life would be 5+4+3+2+1=15.
- Declining-balance method: This decreasing charge method applies aconsistent depreciation rate to the declining net asset balance to yield higherdepreciation charges in the earlier years of an asset's useful life and lowercharges toward the end. Double-declining balance is another version of this method;as its name implies, it doubles the depreciation rate, resulting in very accelerateddepreciation charges.
- Modified accelerated cost recovery system (MACRS): Thisdepreciation method is required for U.S. tax purposes and, unlike GAAP-compliantmethods, fully depreciates assets to a zero value rather than its salvage value. TheIRS provides prescribed spans for useful lives, based on asset class.
When to Use Straight-Line Depreciation
Accountants try to select the method of depreciation that best corresponds with thenature of the fixed asset. A company can use different depreciation methods fordifferent types of fixed assets, but they should use the same method consistently overtime. Straight-line depreciation is a common default because of its practicality:It's easy to calculate, less of an administrative burden and less prone to error.
Simplicity aside, the nature of a fixed asset often makes straight-line depreciation themost fitting choice. When a fixed asset's obsolescence is simply the result of timepassing, straight-line depreciation is an appropriate method. Furniture and fixtures aregood examples of fixed assets that simply lose value as they age. Straight-linedepreciation is also fitting in scenarios where the economic usefulness of an asset,such as a warehouse, is the same in each time period. Also, if revenue generated by thefixed asset is constant over the useful life, the straight-line method may be the bestchoice, such as for a building owned for rental by a landlord.
Straight-line amortization is a similar concept that is applied to intangible assets withdefinite useful lives, such as patents, trademarks and copyrights. Unlike straight-linedepreciation, amortizationusually assumes no salvage value and is calculated on the entire value of the intangibleasset.
Advantages and Disadvantages of Straight-Line Depreciation
The advantages of straight-line depreciation support the method's popularity. Amongthem:
- Straight-line depreciation is easy to calculate and consistently applied.
- It has wide application to many fixed assets, especially when their obsolescence issimply due to passage of time.
- Straight-line amortization schedules are simple and reduce the amount of requiredrecord-keeping.
However, accountants often raise objections to using the straight-line method.Disadvantages noted are:
- Some assets are more correctly depreciated based on output, input or usage.
- It requires the use of MACRS recovery periods to be acceptable for U.S. taxpurposes, prompting the need for additional calculations.
- Some assets experience accelerated obsolescence in their early years, such ascomputers and vehicles.
- Estimates for useful life and salvage value can be subjective and inconsistent amongdifferent companies.
What Numbers Are Included in Straight-Line Depreciation?
Each of the three data points used to calculate straight-line depreciation — assetcost, salvage value and useful life — comes with its own set of considerations.Estimates and judgment are required for the purpose of allocating costs in a systematicand rational manner.
- Purchase price: This data point is based on fact. The purchaseprice includes the cost of the asset plus any labor and material costs needed to putit into service, such as shipping, installation and customization.
- Salvage or scrap value: This is an estimate of how much money canbe received when the asset is removed from service and sold or scrapped. Manycompanies will set this estimate at zero for lack of a more reasonable estimate.Other times, past experience or resale industry guides can be helpful.
- Useful life: This is another estimate, representing the number ofyears the asset is expected to be in service. Useful life is often different fromphysical life; the former represents the time an asset can perform its intendedfunction in its intended way. Often, machinery still has physical life left, but theongoing costs of repairs and maintenance or reduced operating efficiency reduce itsuseful life. Accountants typically use IRS tax tables, past experience or externalsources to help determine the useful life of a fixed asset.
Straight-Line Depreciation Formula
The formula for straight-line depreciation yields a stable, consistent determination ofannual depreciation expense for each period. The formula to calculate annualdepreciation expense using the straight-line method is:
Annual depreciation expense = (cost– salvage value) / useful life
How to Calculate Straight-Line Depreciation
Calculating straight-line depreciation involves only three data points: asset cost,salvage value and useful life (described in steps 1–3). However, it's important tonote that only one of the three is based on hard facts, while the other two areestimates.
These are the steps to follow:
- Determine the fixed asset's all-in cost, which includes the cost of the assetplus any costs to put it into service.
- Estimate the useful life of the asset, meaning, how long it is expected to be inservice.
- Estimate the asset's salvage value, or how much it can be sold for at the endof the useful life.
- Use the standard straight-line depreciation formula, below, to calculate annualdepreciation expense.
- Optional: Divide the annual depreciation expense by 12 to arrive at a monthlydepreciation expense.
- Optional: Divide 1 by the useful life to arrive at an annual depreciation rate. Forexample, five years translates into 1/5, or 20% each year. Then multiply the annualdepreciation rate by the depreciable base.
Examples of Straight-Line Depreciation
Consider the following example of straight-line depreciation. Company KMR Inc. haspurchased a new delivery truck for an all-in purchase price of $100,000 (cost). It paidwith cash and, based on its experience, estimates the truck will likely be in servicefor five years (useful life). Aided by data from a trusted guide for vehicle-pricingestimates, and estimating mileage and future condition, KMR estimates that the deliverytruck will be sellable for about $15,000 (salvage value) at the end of five years.
Based on the formula (cost – salvage value) / useful life, KMR's annual depreciationexpense based on the straight-line method is $17,000 [($100,000 – $15,000) / 5].
To see how this example plays out through asset retirement, see the chart near the top ofthis article and the template provided in the next section.
Free Straight-Line Depreciation Template
Use this template to calculate an asset's straight-line depreciation, aswell as its impact on a company's balance sheet and income statement,by general ledger account.
Download thetemplate
The template has been preloaded with the example in the previous section but can bechanged by updating the three input variables highlighted in yellow.
Calculate & Track Depreciation With NetSuite
While straight-line depreciation may be the simplest of depreciation methods, maintainingmanual spreadsheets of depreciation tables for all of a company's depreciableassets can be complicated, time-consuming and prone to error. Adding to the difficulty,businesses may use different depreciation methods for its various categories of fixedassets, each with its own depreciation schedule. What's more, differentdepreciation schedules may be needed for book and tax purposes, as well. Robustautomated accounting NetSuite CloudAccounting Software, can take over this tedious process, reducing the potentialfor error and freeing employees to work on higher-value activities. Additionally,integration with NetSuite FixedAssets Management can help ensure that depreciation and asset inventory arealigned, records are accurate and depreciation rules are applied consistently.
Conclusion
Straight-line depreciation is a popular method for allocating the cost of fixed assetsover the duration of their useful lives. This method relies on the passage of time tocalculate a consistent amount of depreciation charges in each accounting period. Becauseit is the simplest GAAP-compliant method, it is also the most commonly used in practice.
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Straight-Line Depreciation FAQs
What are the other methods of depreciation?
Other methods of depreciation include units of production, sum of the years' digits,declining balance and modified accelerated cost recovery systems (MACRS). All of thesemethods are GAAP-compliant except for MACRS, which is required by the IRS for U.S. taxpurposes.
How is straight-line depreciation different from other methods?
Straight-line depreciation is different from other methods because it is based solely onthe passage of time.
How does straight-line depreciation factor into accounting?
When depreciation is calculated using the straight-line method, the current period'sdepreciation amount is debited to a depreciation expense account on the income statementand credited to an accumulated depreciation account on the balance sheet. This serves toincrease expenses, which reduces income for the period. It also increases the contraasset account, which reduces the running balance of its related asset when nettedtogether.
What are realistic assumptions in the straight-line method of depreciation?
Two of the three data points required in the formula for straight-line depreciation areestimates: the economic useful life of the asset and the estimated salvage value at theend of the life. The third data point, the asset's cost, is empirically quantifiedbased on purchase price and costs incurred to put the asset into its intended service.
What is straight-line amortization?
Straight-line amortization is asimilar concept to straight-line depreciation, but it is applied to intangible assetswith definite useful lives, such as patents, trademarks and copyrights. Unlikestraight-line depreciation, amortization usually assumes no salvage value and iscalculated on the entire value of the intangible asset.
How do you calculate straight-line depreciation?
Straight-line depreciation is calculated by dividing a fixed asset's depreciablebase by its useful life. The depreciable base is the difference between an asset'sall-in costs and the estimated salvage value at the end of its useful life. The usefullife is represented in terms of years the asset is expected to be of economic benefit.
What is a straight-line depreciation example?
Let's say a company purchases a new delivery truck for $100,000 (cost). The companypays with cash and, based on its experience, estimates the truck will be in service forfive years (useful life). Aided by third-party data on vehicle-pricing estimates, andestimating mileage and future condition, the company estimates that the delivery truckwill be sellable for about $15,000 (salvage value) at the end of five years. The formulato calculate annual depreciation using the straight-line method is (cost – salvagevalue) / useful life. Applied to this example, annual depreciation would be $17,000, or($100,000 – $15,000) / 5.
What is the formula for depreciation
Using the straight-line method, the formula for annual depreciation expense is:
(cost – salvage value) / useful life = Annual depreciation expense
Why do we use straight-line depreciation?
Accountants use straight-line depreciation because it is easy to calculate, is less of anadministrative burden and is less prone to error. It is also the most fitting choice forfixed assets that become obsolete as they age with the simple passage of time.
