What Is Straight Line Depreciation?

Straight-line depreciation spreads the cost of an asset evenly over the time it will be used, also known as its "useful life." It requires only three inputs to calculate: asset cost, useful life and estimated salvage value — meaning, how much the asset is likely to be worth at the end of its useful life. Another important term to understand is "depreciable base," which is the difference between the asset's cost and its salvage value. The depreciable base is divided by the number of years the asset is estimated to be useful, in order to calculate the annual depreciation expense. In each accounting period, this depreciation amount is uniformly charged, stepping down the asset's book value until it reaches its salvage value.

Why is Straight-Line Depreciation Important?

Depreciation is important because, by matching expenses with revenue, a company's overall profitability is determined more accurately. The straight-line method of depreciation, specifically, results in even, stable depreciation charges, so it makes budgeting and financial forecasting easier. Additionally, the consistent charges assist operating profitability and cash flow analysis, since they are easily identified and removed.

What Numbers Are Included in Straight-Line Depreciation?

Each of the three data points used to calculate straight-line depreciation — asset cost, 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 systematic and rational manner.

• Purchase price: This data point is based on fact. The purchase price includes the cost of the asset plus any labor and material costs needed to put it into service, such as shipping, installation and customization.
• Salvage or scrap value: This is an estimate of how much money can be received when the asset is removed from service and sold or scrapped. Many companies 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 of years the asset is expected to be in service. Useful life is often different from physical life; the former represents the time an asset can perform its intended function in its intended way. Often, machinery still has physical life left, but the ongoing costs of repairs and maintenance or reduced operating efficiency reduce its useful life. Accountants typically use IRS tax tables, past experience or external sources 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 of annual depreciation expense for each period. The formula to calculate annual depreciation expense using the straight-line method is:

Annual depreciation expense = (cost – salvage value) / useful life

Reducing Balance Method

Reducing Balance Method: Definition

Under the reducing balance method, the amount of depreciation is calculated by applying a fixed percentage on the book value of the asset each year.

In this way, the amount of depreciation each year is less than the amount provided for in the previous year. This is because the book value used to compute the depreciation expense is continually reduced from year to year.

Reducing Balance Method: Formula

Use the following formula to calculate depreciation under the reducing balance method:

Depreciation = Asset Book Value * Depreciation Rate

Depreciation = Asset book value x Depreciation rate

Where:

• Depreciation : is the dollar amount lost in value.
• Asset book value : is the value of the asset for accounting purposes.
• Depreciation rate : is the percentage decline in the asset's value.

Example: Calculating Depreciation Under Reducing Balance Method

On 1 January 2016, XYZ Limited purchased a truck for $75,000. Depreciation is estimated at 20% per year on the book value.

Required: Calculate the truck's depreciation for 2016, 2017, and 2018.

Solution 2016

The book value at the beginning of 2016 is $75,000. Depreciation for 2016 is $75,000 × 0.2 = $15,000.

2017

The book value at the beginning of 2017 is $75,000 - $15,000 = $60,000. Depreciation for 2017 is $60,000 × 0.2 = $12,000.

2018

The book value at the beginning of 2018 is $60,000 - $12,000 = $48,000. Depreciation for 2018 is $48,000 × 0.2 = $9,600.

Notes

Notice that the depreciation provided in 2018 ($9,600) is less than the amount of depreciation provided in 2017 ($12,000). In turn, this is less than the amount provided in 2016 ($15,000). The reason for this is that the rate of depreciation (20% in this case) is being applied to the book value, which continually reduces each year. In 2016, the book value was $75,000, while in 2017, it fell to $60,000. A year later, it reduced to $48,000. Remember that the rate of depreciation remains constant but it is applied to a lesser amount (i.e., book value) each year. Hence, the amount of depreciation each year is lower. The reducing balance method is also known as the reducing installment method. It is especially useful for fixed assets whose value deteriorates faster in the earlier years of usage (e.g., cars, office equipment, and small machinery).