When you own a business, chances are that you’ll need to buy both basic equipment like a computer and a POS system as well as specialized equipment, like coffee machines for a cafe, or industrial equipment for a manufacturer. Every asset you acquire has a set value at the time of purchase, but that value changes over time. As a business owner, it’s important to know how to accurately report the value of your assets each year, and one of the best methods for doing so is called straight-line depreciation.
In this article, you’ll learn:
What depreciation is and how it works
How to calculate straight line depreciation
When to use the straight line method of depreciation
Other depreciation methods you can use
To understand straight-line depreciation, you first need to understand how depreciation works. Most people have experienced the idea of depreciation when buying a car. The common knowledge is that your car decreases in value the moment you drive off the lot, and keeps going down as the car gets older and drives more miles. That decrease in value? That is depreciation!
So if depreciation is the loss of value of an asset, straight-line depreciation is a formula that allows you to calculate both the rate of that loss and the value of your assets at any specific point in time. The method is called “straight line” because the formula, when laid out on a graph, creates a straight, downward trend, with the same rate of loss per year.
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To determine the value of your assets using the straight-line depreciation method, you’ll need the following three figures:
The purchase price of the asset: This is the original cost you paid for the asset, including taxes, shipping, and other associated fees.
The salvage value of the asset: This is how much you feel you can sell the asset for once it is no longer useful. If you’re still thinking about cars, this would be the amount you could sell your vehicle to a scrap yard.
The estimated useful life of the asset: In layman's terms, how long will you be able to use this asset before it needs to be sold at the salvage value? This is measured in years.
Once you have all your pieces ready, here’s how to calculate depreciation using the straight-line method:
Straight Line Depreciation Rate = (purchase price - salvage value) / estimated useful life
Once you know the yearly depreciation rate, you can simply subtract the depreciation value from the purchase price each year to determine the asset’s current value at any point in time.
For Tax Deductions: Annual depreciation expense is a business expense like any other purchase, and can be used in your financial statements, such as your income statement, to help you save during tax season. The IRS allows the straight-line method to be used for most business assets, but it’s most useful for intangible assets, such as invoicing software.
For Accounting and Valuation of your Business: To understand the total value of your business, you need to take into account the depreciated value of each one of your fixed assets. This is extremely helpful in determining how your business is doing, and whether it’s truly turning a profit, or falling behind.Other Types of Depreciation Methods
This method is useful for assets that depreciate quickly after purchase, like computers, which lose their value very quickly, even though they might operate well for a long time. For the first year, the double declining balance method takes the depreciation rate from the straight-line method and doubles it. For subsequent years, this method uses the same doubled rate on the remaining balance, instead of being based on the original purchase value.
For Year 1, Depreciation = [(purchase price-salvage value)/estimated useful life] x 2
For Year X, Depreciation = (Doubled Rate) x (Remaining Balance)
*Double declining balance depreciation is not accepted for tax deductions.
Like the double-declining balance method, this is an accumulated depreciation formula where an asset loses more value at the start of its life than at the end. For this method, you first add the digits of the year(s) for the estimated useful life together: so if the useful life is 5 years, the sum of the digits is 5+4+3+2+1=15. Then you create a fraction for each year with the remaining years on top and the sum of digits on the bottom: so when there are 5 years left, the year’s fraction is 5/15. For each year, the percentage value of that fraction is the depreciation rate, which is then applied in this way:
(Year X’s %) x (original purchase price - salvage value) = Year X’s Depreciation
The units of production method works similarly to the straight-line method, but instead of basing the rate of decline on a useful life in years, it does so based on production. Instead of seeing your depreciation rate in money, you see a rate based on the number of units produced, so you can accurately predict how many more units you think you’ll get out of a piece of equipment before salvaging it. Here’s what the formula for units of production depreciation looks like:
yearly depreciation by unit numbers = [(purchase price - salvage value) x (# of units produced this year)] / (predicted # of units produced during the estimated useful life)
One important thing to note about straight-line depreciation: while it is the easiest depreciation method to use (especially if you aren’t an accountant by trade), it isn’t always perfect or accurate, so take your results with a grain of salt. That being said, we hope this article has helped you what depreciation is, how it works, and how it can help your business be successful!
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