Straight Line Depreciation Method
Analyzing an Income Statement and Straight Line Depreciation
Straight line depreciation is a method by which business owners can stretch the value of an asset over the extent of time that it's likely to remain useful. It's the simplest and most commonly used depreciation method when calculating this type of expense on an income statement, and it's the easiest to learn.
The calculation is straightforward and it does the job for a majority of businesses that don't need one of the more complex methodologies.
How to Calculate Straight Line Depreciation
Take the purchase price or acquisition cost of an asset, then subtract the salvage value at the time it's either retired, sold, or otherwise disposed of. Now divide this figure by the total product years the asset can reasonably be expected to benefit your company. This is referred to as its "useful life" in accounting jargon.
Written out as a math equation, the calculation looks like this:
Straight Line Depreciation = Purchase Price of Asset – Approximate Salvage Value / Estimated Useful Life of Asset
Straight Line Depreciation Example
Let's say you own a small business and you decide you want to buy a new computer server at a cost of $5,000. You estimate that there will be $200 in salvage value for the parts at the end of its useful life, which you can sell to recoup some of your outlay.
Existing accounting rules allow for a maximum useful life of five years for computers, but your business has upgraded its hardware every three years in the past. You think three years is a more realistic estimate of its useful life because you know you're likely going to dispose of the computer at that time.
Using this information, you can calculate the straight line depreciation cost:
- Step I: $5,000 purchase price - $200 approximate salvage value = $4,800
- Step 2: $4,800 ÷ 3 years estimated useful life = $1,600
- Answer: $1,600 annual straight line depreciation expense
How Depreciation Charges Fit With Accounting Tools
Here's what would actually happen if you bought the computer for cash:
- You would move $5,000 from the cash and cash equivalents line of the balance sheet to the property, plant, and equipment line of the balance sheet.
- The cash flow statement would show a $5,000 outflow for capital expenditures at the same time.
- You would charge $1,600 to the income statement each year for three years. You'd actually show profits reduced by $1,600 in year one, by $1,600 in year two, and by $1,600 in year three, even though you parted with $5,000 in year one and $0 each year thereafter.
- Each of those $1,600 charges would be balanced against a contra account under property, plant, and equipment on the balance sheet. This is known as accumulated depreciation, which effectively reduces the carrying value of the asset. For example, the balance sheet would show a $5,000 computer offset by a $1,600 accumulated depreciation contra account after the first year, so the net carrying value would be $3,400.
- The carrying value would be $200 on the balance sheet at the end of three years. The depreciation expense would be completed under the straight line depreciation method, and management would retire the asset. The sale price would find its way back to cash and cash equivalents. Any gain or loss above or below the estimated salvage value would be recorded, and there would no longer be any carrying value under the fixed asset line of the balance sheet.
Advantage of Straight Line Depreciation
One quirk of using the straight line depreciation method on the reported income statement arises when Congress passes laws that allow for more accelerated depreciation methods on tax returns.
These are faster than what management decides to employ on the reported financial statements put together under the Generally Accepted Accounting Principles (GAAP) rules. Management is likely going to take advantage of this because it can increase intrinsic value.
GAAP is a collection of accounting standards that set rules for how financial statements are prepared. It's based on long-standing conventions, objectives and concepts addressing recognition, presentation, disclosure, and measurement of information.
Although the reported earnings figures more accurately represent economic reality due to the smoothed nature of the straight line depreciation method, taking the tax deduction upfront by accelerating depreciation on the tax return can mean more cash saved this year.
Disadvantage of Straight Line Depreciation
This approach can result in a problem, however. The tax records won't match the accounting records. Fortunately, they'll balance out in time as the so-called tax timing differences resolve themselves over the useful life of the asset.
The simplified version of these adjustments is that a special deferred tax asset will be put on the balance sheet to serve as a way to adjust for the difference between the income statement and the cash flow statement. That deferred tax asset will be reduced over time until the reported income under GAAP and the reported income to the IRS align at the end of the straight line depreciation schedule.
The Bottom Line
There are generally accepted depreciation estimates for most major asset types that provide some constraint. They're found in publications referred to as Asset Life tables.
For example, the Clorox Company, one of the world's largest cleaning supply manufacturers, uses the following depreciation schedule in its calculations:
- Land improvements are depreciated over 10 to 30 years.
- Buildings and leasehold improvements are depreciated over 7 to 40 years.
- Machinery and equipment are depreciated over 3 to 15 years.
- Computer equipment is depreciated over 3 years.
- Capitalized software cost is depreciated between 3 to 7 years.
The straight line depreciation calculation should make it clear how much leeway management has in managing reported earnings in any given period. It might seem that management has a lot of discretion in determining how high or low reported earnings are in any given period, and that's correct. Depreciation policies play into that, especially for asset-intensive businesses.