Understanding the Straight-Line Method of Depreciation

Accounting
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Fincent Team

Starting a new company is a highly bold move that you make in your career. While the experience could be exhilarating, it also scares you as there are several challenges a business brings along with it.

Once you decide on starting a new business, you will have to acquire finances, assets, and office space, or a domain if it is an online business. You need to understand how the functional as well as the operational aspects of your business work. The multiple choices you will have to make while starting your own creative business will make things confusing, but if you are well aware of the features of all alternatives, you are good to go.

Like every other business, your purchase assets will have to be written off over the years. There are several ways of depreciating assets. Here's everything you need to know about the most commonly used method of depreciation, the straight-line depreciation method.

What Is Straight-Line Depreciation?

Companies tend to use the straight-line method of depreciation for depreciating most of their assets. In the straight-line depreciation method, companies depreciate all of their assets at a constant rate. The amount is calculated at the beginning of the first year, and the same amount is reduced from the asset's value every year.

The reason why small and big companies alike use the straight-line method is the ease of calculations. You need to calculate the depreciation amount once and keep reducing it from the asset's value. You can quickly get away with all the complex calculations involved in calculating depreciation using the other depreciation methods.

What Can Be Depreciated?

As a new business owner, you should be clear on the financial element brought in by every aspect of your business. Before you decide on a method of depreciation to be used, you must figure out what objects can be depreciated.

Mostly, all tangible properties of your business will be subjected to depreciation as they tend to get obsolete or stop working over time due to degradation. The degradation is a loss for your business, and it should be recorded as an expense as regular wear and tear affects the working of machinery.

Some intangible assets are also depreciated as they tend to lose value as time passes. There are some assets like how to calculate cash flow, investments, etc., that do not lose value quickly. These kinds of assets are not subjected to any depreciation.

How to Calculate Straight-Line Depreciation?

As a small business owner, you should know how to calculate depreciation. It is pretty simple to do so using the straight-line method. There are three values that you would need while calculating the amount of depreciation you will write off every year:

  1. The cost or the purchase price of the asset that will be subjected to depreciation
  2. The salvage or the scrap value of the asset: The scarp value is the price you get after you sell the asset at the end of its useful life.
  3. The valuable years or the life of the asset

The straight-line depreciation formula is quite simple. You have to calculate the depreciation amount for one year based on the asset's cost price. The exact amount is written off every year from the remaining value of the asset.

Annual depreciation = (Purchase Price – Salvage value of the asset) / Useful life of the asset (in years)

The amount obtained as a result of this formula will have to be reduced from the asset's book value every year. You will repeat the process till you reach the scrap or the salvage value of the asset. The book value refers to the total value of the asset at a given point in time.

Though the process of calculating depreciation using the straight-line method is easy, it might be difficult for you as a small business owner to keep track of all of these assets.

What do you know about fixed and variable costs? It would help if you outsourced your business' bookkeeping to someone who can help you out when the situation gets tricky. Also, hiring a part-time accountant will help you focus on your creative business better.

Straight-Line Depreciation in Action

You must understand how the depreciation amount of a particular asset is calculated. Let's assume that you buy a photocopy machine for your business for $2,000. The estimated salvage value of the machine is $500 and the utility period is five years.

To get the depreciation amount, you can calculate the annual depreciation using the formula stated above:

Annual Depreciation = ($2,000 - $500) / 5 = $1500 / 5 = $300

So, you will now reduce $300 from the asset every year until you reach the asset’s salvage value.

Year 1: $2,000 - $300 = $1,700

Year 2: $1,700 - $300 = $1,400

Year 3: $1,400 - $300 = $1,100

Year 4: $1,100 - $300 = $800

Year 5: $800 - $300 = $500

Once you reach the asset's salvage value, you can stop subtracting the amount of depreciation from the asset's book value.

How Is Straight-Line Depreciation Different From Other Methods?

Every method of calculating depreciation formula is unique. In most cases, the depreciation used for a specific asset depends on its nature. You can write off some of these assets based on the usage or the degree of wear and tear.

There are several kinds of depreciation methods. However, the most commonly used ones are the double-declining method and the straight-line method. There's also another kind called the unit of production.

Understand double entry accounting for your small enterprise in 2021

The unit of production is similar to the straight-line method. It measures the units of production instead of measuring them in dollars. The units of production include elements like the number of wrappers produced by a factory machine, etc.

The depreciation will have to be calculated every year based on the asset's book value when you use a double-declining balance method. However, in the straight-line method, there is only one fixed amount that is accounted for depreciation. The exact amount will be subtracted from the book value of the asset every yeYou can calculate the depreciation amount using the double-declining method using the formula below:

2 * The Rate of Depreciation * Book Value of the Asset

The number of depreciation changes every year as the book value of the asset changes as a result. People use this method to calculate depreciation for several tools and equipment that tend to wear out with use.

When Should I Use the Straight-Line Method?

The straight-line method has great potential. However, you need to know when to use it. Listed below are some areas and reasons for using the straight-line method of calculating and applying depreciation:

  1. To deduct your expenses on your annual financial statement

    Depreciation of an asset is an expense for the business. As a result, it has to be written off like all the other expenses.
  2. To come to a value of the business.

It is essential to understand your assets' depreciation. You should take into account the value by which all of your assets have depreciated over time. It will indeed reduce the profits you have, but it will better picture the business conditions.

How Does Straight-Line Depreciation Factor Into Your Accounting?

As a small business owner, you might find it intimidating to dive into the financials of your business. However, it would be best to understand how basic operations like depreciation work and impact your company.

You can make the entry of depreciation in the books of accounts in the following manner:


As depreciation is an expense for a business, the depreciation account will be debited. The reduction in the accumulated depreciation account, which is considered to be an asset, will result in the crediting of the accumulated depreciation account.

Conclusion

Any asset that brings value to the company tends to lose its worth as time passes. Understanding and calculating asset depreciation might be a hassle, however, and it's always a good idea to outsource your bookkeeping needs to an industry leader like Fincent.

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