The straight line depreciation method gives you a realistic picture of your business’s profit margin using long-term assets. Straight line depreciation can be calculated on assets such as manufacturing equipment, vehicles, office furniture, computers, and office buildings.
Let’s say, a company purchases a machinery of $10,500 with a useful life of 10 years, and a salvage or scrap value of $500. The accountant should deduct salvage value of the machinery from its original price, and divide the amount with it’s useful life. Using the straight line basis method, the depreciation for the machinery will be $1,000 (($10,500 – $500) / 10). This states that instead of writing off the complete machinery cost in the existing time period, the company will have a depreciation expense of $1,000. The company will record $1000 as an expense in contra-account, which is also known as accumulated depreciation until the salvage value of $500 will be left in the accounting books.
What Are Some Examples of Using Straight Line Depreciation Method?
The cumulative depreciation is recorded on the balance sheet, and it displays the total depreciation amount from the date the asset was acquired to the date on the balance sheet. The straight line method of depreciation provides small business owners with an easy and simple formula for depreciation. In setting up your small business accounting system, knowing your depreciation methods can help you choose the right method that matches the pattern of usage of your fixed assets. Once calculated, depreciation expense is recorded in the accounting records as a debit to the depreciation expense account and a credit to the accumulated depreciation account. Accumulated depreciation is a contra asset account, which means that it is paired with and reduces the fixed asset account. Accumulated depreciation is eliminated from the accounting records when a fixed asset is disposed of. In Straight line depreciation method, the depreciation charged amount is constant throughout the life of the asset.
Once you have calculated this figure, subtract that amount each year from the asset value to find its current value or book value. The straight line depreciation formula is a simple way of calculating the cost of an asset over time. It’s calculated by subtracting the salvage value of an asset from its cost. This is then divided by the estimated projected useful lifetime of the asset. While it’s simple to calculate straight line depreciation, there are drawbacks, such as possible inaccuracies with the projected estimated useful lifetime of the asset in question. When calculating a business’s contra account, bad debts, depletion and depreciation of the company’s assets are all crucial deductions to make.
Overview: What is straight line depreciation?
There are advantages to using both the straight line and the declining balance methods. You should choose the right one depending on your business needs. The https://www.bookstime.com/ method is easier to use, which will result in less complicated accounting. However, the declining balance method can be more accurate when assessing the value of an asset, for example, if you buy a new computer for your business, it will lose more value early on. However, assets like real estate or furniture steadily lose their value over time, therefore the straight line depreciation method is more suitable in these cases. The unit-of-production method measures depreciation by units instead of dollar amounts.
- The accountant should deduct salvage value of the machinery from its original price, and divide the amount with it’s useful life.
- Because the useful life and the salvage value are both based on expectation, the depreciation can be very inaccurate.
- This method can be used to depreciate assets where variation in usage is an important factor, such as cars based on miles driven or photocopiers on copies made.
- Owning a business requires constantly monitoring a variety of assets.
And, a life, for example, of 7 years will be depreciated across 8 years. FREE INVESTMENT BANKING COURSELearn the foundation of Investment straight line depreciation banking, financial modeling, valuations and more. Hence, the Company will depreciate the machine by $1000 annually for eight years.
What is the Formula for Calculating Straight Line Depreciation?
Note that the account credited in the above adjusting entries is not the asset account Equipment. Instead, the credit is entered in the contra asset account Accumulated Depreciation. Therefore, we allocate $4,500 of the cost to depreciation expense every year.
How is the formula for Straight Line Depreciation different from other formulas?
The most important difference between this formula and other common depreciation formulas is the denominator. Other methods have a denominator of 1 or 1/2 depending on whether an asset was acquired during its first year or after it had been in use 1 year. The denominator in straight-line depreciation is 1/ Estimated Useful Life, which has the effect of making 1/ Estimated Useful Life much larger than 1 or 1/2 when an asset is new.
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Straight line method is easy to understand, and has less probability of having errors during the asset life. However, the straight line method faces many shortcomings as well. For instance, if there are fast technological improvements, the asset would tend to depreciate more quickly than the estimated time period. Also, this method excludes the loss in the value of an asset in the short-run. And the older it gets, the more maintenance costs the company would bear. To understand the true value of a business, including all of its assets, you need to have an accurate calculation of depreciation. If a business is trying to determine their overall profitability, they may create an income statement that includes a current figure on the depreciation of assets.
The salvage value is the amount the asset is worth at the end of its useful life. Whereas the depreciable base is the purchase price minus the salvage value.