What is Straight Line Depreciation? 

As you own and utilise assets in your business, they will naturally experience ‘wear and tear’. Depreciation is an invaluable financial tool that recognises this decline on your balance sheet, dispersing a depreciating asset’s cost over its anticipated lifespan.  

Depreciation assists modern businesses in recognising expenses and related income, creating a more precise representation of their profitability.  

Even though a variety of depreciation methods adhere to the Australian Accounting Standards Board, the straight-line depreciation method stands out as the most widely employed, given its simplicity and ease of determining an asset’s depreciation over its useful life.  

This article delves deep into straight line depreciation, breaking down its workings, advantages, and potential drawbacks. Whether you’re a business leader curious about financial concepts or a property owner planning for the long term, consider this your go-to guide.  

What is Straight Line Depreciation? 

Straight line depreciation is a straightforward method that allows companies to gradually reduce the reported value of their depreciating assets such as machinery and equipment consistently over the asset’s useful life. 

When straight line depreciation accountants utilise this method, they opt for a sound approach that is effective for assets that age and lose value over time. The concept allows you to spread an asset’s cost, known as the asset cost, evenly over its ‘useful life’. 

To calculate straight line depreciation, the following factors are used: 

• Asset cost: The purchase price for the asset, including other associated costs, such as transportation, installation, and modifications required to make it functional. 

• Resale or disposal value: A projected value indicating the potential financial return upon selling or discarding the asset when it’s no longer in service. Many organisations put this value at nil if they lack a more precise assumption. Alternatively, you can apply previous experiences or guidelines from the resale marketplace. 

• Effective life: Another assumption indicating how many years the asset is projected to be in use. The expected lifespan often differs from the actual physical lifespan; it represents the period during which the asset can perform its designated function as expected. Sometimes, equipment may still be physically functioning. However, increased maintenance costs or a decline in operational efficiency can shorten the effective life. 
   
  You must also consider the ‘written down value’, which is the differential between the asset’s starting price and its eventual residual value. 
   
  Depreciation aligns costs with revenues, providing a more precise view of a company’s total profitability. In particular, the straight line depreciation method ensures consistent, regular depreciation charges, making it simpler to plan budgets and anticipate financial trends. 
   
  Plus, with its predictable charges, it aids in assessing operational profitability and cash flow, given their easy identification and exclusion. 

Definition and Explanation 

Straight-line depreciation is a widely used method of calculating the depreciation of a fixed asset over its useful life. It is a simple approach that assumes the asset loses its value constantly over time.  

The straight-line method is based on the idea that the asset’s value decreases uniformly over its useful life, resulting in a consistent annual depreciation expense. This predictability makes it easier for businesses to plan and budget for their depreciation expenses, ensuring a stable financial outlook. 

Calculating Depreciation: The Straight Line Depreciation Formula 

So, how do you calculate depreciation using the straight line method? 

The straight line depreciation rate is uniform for the duration of the asset’s effective life. The annual depreciation expense is calculated by dividing the initial cost by the useful life the asset is expected to have. 

Annual depreciation expense = (asset’s cost – salvage value) / asset’s effective life 

Subtracting the salvage value from the asset’s cost and dividing the result by the asset’s effective life produces a consistent and predictable annual depreciation expense. This straightforward calculation helps businesses maintain accurate financial records and simplifies budgeting. 

Example of Straight Line Depreciation Method 

Let’s consider an example of a company that purchases a piece of equipment for $10,000 with an estimated salvage value of $2,000 and a useful life of 5 years. Using the straight-line method, the annual depreciation expense would be: 

Annual depreciation expense = asset’s cost/asset’s effective life 

This value is consistently subtracted in each accounting period, reducing the written-down value until it aligns with the residual value. 

Understanding your assets’ depreciation ensures your financial records accurately reflect their diminishing value, aids in your budgeting efforts, and plays a crucial role in your business’s financial health and transparency. 

This method ensures that the depreciation is evenly spread out, resulting in a stable and predictable annual charge. It’s a practical choice, requiring less calculation, less administrative work, and fewer chances for error when compiling a tax depreciation schedule. 

Applying Straight Line Depreciation: When is the Right Time? 

Bookkeepers, accountants, and business owners often prefer the straight-line depreciation method, as it aligns seamlessly with the characteristics of the particular depreciating asset, especially when an asset’s depreciation is primarily due to time lapse. 

Common examples of such depreciating assets are fixtures and fittings, which depreciate with time. Also, straight line depreciation is applicable when an asset like a warehouse has steady economic usefulness. 

Furthermore, if the earnings produced by the depreciating asset remain steady over its useful tenure, then the straight-line method is a sound choice, such as for a building owned for leasing purposes by a property owner. 

Advantages and Disadvantages of Straight Line Depreciation 

Pros: 

• The method’s simplicity and consistent application make it an attractive choice for depreciation. 

• It applies to many depreciating assets, particularly when their diminishing value is attributed to elapsing time. 

• The straightforward amortisation schedules offered by straight line depreciation minimises administrative paperwork’s complexity. 

Cons: 

• Certain assets’ depreciation may be more accurately calculated based on factors such as output, input, or utilisation. 

• Certain assets, such as technological devices and vehicles, may undergo faster obsolescence, especially in their initial years of use. 

• An asset’s useful life and salvage value assessment can vary greatly, leading to subjectivity and discrepancies across different organisations. 

Alternative Methods to Calculating Straight Line Depreciation 

Although straight line depreciation often comes to mind when we talk about depreciation, know that it’s not the only method you’ve got at your disposal. A well-informed entrepreneur like yourself has many methods to choose from, and each one might be more suitable for a particular scenario than straight line depreciation. Let’s delve briefly into these other methods.  

Diminishing Value Methodology  

With this approach, the asset’s depreciation is steep initially but softens over time. The Diminishing Value Method is often preferred when assets lose considerable value in the initial years after purchase.  

Units of Production Method  

Looking for a depreciation method that bases costs on production levels? Units of Production could work. It calculates depreciation based on the quantity of goods produced by the asset.  

Declining Balance Method 

The declining balance method is an alternative depreciation method that assumes the asset loses its value faster in the early years of its life. This method is often used for assets that lose their value rapidly, such as computers or vehicles. The declining balance method calculates the depreciation expense by multiplying the asset’s book value by a declining balance percentage. 

For example, if a company purchases a computer for $1,000 with an estimated useful life of 3 years, the declining balance method would calculate the depreciation expense as follows: 

• Year 1: $1,000 x 33.33% = $333 

• Year 2: $667 x 33.33% = $222 

• Year 3: $445 x 33.33% = $148 
   
  The declining balance method results in a higher depreciation expense in the early years of the asset’s life, which can provide tax benefits for companies by accelerating the recognition of depreciation expenses. 

Accounting for Straight Line Depreciation 

Straight-line depreciation is recorded as a debit to the depreciation expense account and a credit to the accumulated depreciation account. The accumulated depreciation account is a contra-asset account that reduces the fixed asset account. 

For example, if a company records a depreciation expense of $1,600 using the straight-line method, the journal entry would be: 

• Debit: Depreciation Expense ($1,600) 

• Credit: Accumulated Depreciation ($1,600) 
   
  The accumulated depreciation account would be increased by $1,600, resulting in a net book value of the asset that reflects its decreased value over time.  
   
  Using the straight-line method, companies can accurately calculate their depreciation expenses and reflect the reduced value of their investments over time. This method is widely used due to its simplicity and consistency, making it an essential tool for accountants and business owners. 

Key Takeaways 

• The straight line depreciation method is easy to calculate, making it less prone to errors. Thus, it reduces the administrative burden. 

• This method evenly distributes an asset’s cost over its useful life. 

• The useful life and salvage value estimates can be subjective and vary across companies. 

• Knowing when to apply straight line depreciation is vital. It’s most suitable for assets that don’t experience rapid obsolescence, such as buildings and furniture. 

• The method has its pros, such as simplicity and consistency, but also cons, like the inability to account for accelerated depreciation frequently seen in assets like computers and vehicles. 

• While straight line depreciation is widely used, alternative methods include activity-based, decreasing-balance, units-of-production, and sum-of-the-years’-digits methods. These methods might be more suitable for certain assets or business scenarios. 

• An accurate assessment and calculation of depreciation are essential. They significantly affect taxes, financial reporting, and shareholder confidence, and inappropriate calculations can lead to penalties. 

Learn the Best Way to Calculate the Depreciation on Your Asset 

If you want to learn more, speak with our experts at Duo Tax today. We’ll help you determine the depreciation available on your assets and your options for maximising it.