Running a business isn’t cheap, especially if your company requires the use of expensive items like heavy-duty machinery, computer software, or vehicles to operate. While the upfront cost of these items can be shocking, calculating depreciation can actually save you money, thanks to IRS tax guidelines. There are multiple ways companies can calculate the depreciation of an item, with the easiest and most common method being the straight-line depreciation method.
To help you calculate the loss of value of a business asset, we’ve created this guide to help you understand and calculate straight-line depreciation. Read through to learn more about the straight-line method of depreciation, or use the links below to jump to a section of your choice.
- What is straight-line depreciation?
- How to calculate straight-line depreciation
- Final notes
Straight-line depreciation is an accounting method that measures the depreciation of a fixed asset over time. In other words, it measures how much value an item loses over time. The method assumes a fixed asset will lose the same amount of value each year of its useful life until it reaches its salvage value. To help you understand this definition better, let’s define a few key terms:
- Depreciation: The decrease in a physical asset’s worth
- Fixed asset: A long-term tangible piece of property or equipment that a company owns and uses to produce revenue
- Useful life: An accounting measure of the number of years an asset is expected to remain in operation and help generate revenue
- Salvage value: The estimated value of an asset at the end of its useful life. Also called scrap value or residual value, salvage value is used to calculate an asset’s annual depreciation cost.
By estimating depreciation, companies can spread the cost of an asset over several years. The straight-line depreciation method is a simple and reliable way small business owners can calculate depreciation.
The straight-line method of depreciation isn’t the only way businesses can calculate the value of their depreciable assets. While the straight-line method is the easiest to use, sometimes companies may need a more accurate method. Below are a few other methods one can use to calculate depreciation.
Double-declining balance method
With the double-declining balance method, higher depreciation is posted at the beginning of the useful life of the asset, with lower depreciation expenses coming later. This method is an accelerated depreciation method because more expenses are posted in an asset’s early years, with fewer expenses being posted in later years. This approach works by calculating depreciation as a percentage and then depreciating the asset at twice the percentage rate.
Units of production method
Manufacturing businesses typically use the units of production method. Depreciation is calculated using this method by looking at the number of units generated in a given year. This method is useful for businesses that have significant year-to-year fluctuations in production.
If your company uses a piece of equipment, you should see more depreciation when you use the machinery to produce more units of a commodity. If production declines, this method lowers the depreciation expenses from one year to the next.
The straight-line method of depreciation is different from other methods because it assumes an asset will lose the same amount of value each year. With the double-declining balance method, an asset loses more value in the early years of its useful life. With the units of production method, depreciation is determined by the usage of an asset.
The best time to use the straight-line depreciation method is when you don’t expect an asset to have a specific pattern of use over time. Straight-line depreciation is often the easiest and most straightforward way of calculating depreciation, which means it’ll result in fewer errors.
Calculating depreciation is an essential part of business accounting and staying on top of taxes. For business purposes, depreciation is just an expense, which is why you want to ensure it’s calculated correctly. When creating an income statement, you’ll debit your depreciation expenses, while creating a credit for an asset called the accumulated depreciation. The straight-line depreciation method can help you find an asset’s book value when you subtract depreciation from an asset.
The IRS allows businesses to use the straight-line method to write off certain business expenses under the Modified Accelerated Cost Recovery System (MACRS). When it comes to calculating depreciation with the straight-line method, you must refer to the IRS’s seven property classes to determine an asset’s useful life. These seven classes are for property that depreciates over three, five, seven, 10, 15, 20, and 25 years. For example, office furniture and fixtures fall under the seven-year property class, which is the amount of time you have to depreciate these assets.
Now that you know what straight-line depreciation is and why it’s important, let’s look at how to calculate it. The three numbers you’ll need to calculate straight-line depreciation include:
- Purchase price: The total cost of an asset, including shipping, taxes, and any applicable fees
- Salvage value: The price you believe you can sell the asset for once it reaches the end of its useful life
- Useful life: How long you’ll be able to use the asset
With these numbers on hand, you’ll be able to use the straight-line depreciation formula to determine the amount of depreciation for an asset.
To calculate the annual depreciation expense of an asset, subtract the salvage value of the asset from the initial price (total depreciable cost). Then, you’ll divide the total depreciable cost by the asset’s useful life. Below is what the straight-line depreciation formula looks like:
Annual depreciation expense = (purchase price − salvage value) / useful life
To get a better understanding of how to calculate straight-line depreciation, let’s look at a few examples below.
Let’s say you own a tree removal service, and you buy a brand-new commercial wood chipper for $15,000 (purchase price). Your tree removal business is such a success, your wood chipper will last for only 5 years until it needs to be replaced (useful life). You believe after 5 years you’ll be able to sell your wood chipper for $3,000 (salvage value). Here’s how you would calculate your wood chipper’s depreciation using the straight-line method:
Annual depreciation per year = (Purchase price of $15,000 − salvage life of $3,000) / useful life of 5 years
Annual depreciation per year = $12,000 / 5
Annual depreciation per year = $2,400
According to the straight-line method of depreciation, your wood chipper will depreciate $2,400 every year.
Now, let’s assume you run a large fishing business that sets out on the Bering Sea every summer to capture fresh salmon. You buy a new vessel for $280,000 to help increase production. According to the IRS’s standard use of life, vessels fall under the 10-year property life. Once that 10-year period is up, you believe you can sell your vessel for $70,000. Using the straight-line depreciation formula, here’s how much your fishing vessel will depreciate each year:
Annual depreciation per year = (Purchase price of $280,000 − salvage life of $70,000) / useful life of 10 years
Annual depreciation per year = $210,000 / 10
Annual depreciation per year = $21,000
When crunching numbers in the office, you can record your vessel depreciating $21,000 per year over a 10-year period using the straight-line method.
Lastly, let’s pretend you just bought property to build a new storefront for your bakery. You installed a fence around the entire plot of land, which falls under the 15-year property life. The initial cost of the fence was $25,000, and you think you can scrap the wood for $3,000 at the end of its useful life. Using the straight-line depreciation method, here’s how much your fence will depreciate each year:
Annual depreciation per year = (Purchase price of $25,000 − salvage life of $3,000) / useful life of 15 years
Annual depreciation per year = $22,000 / 15
Annual depreciation per year = $1,467
After building your fence, you can expect it to depreciate by $1,467 each year. Additionally, you can calculate the depreciation rate by dividing the depreciation amount by the total depreciable cost (purchase price − estimated salvage value). In this case, the depreciation rate of your fence will be 6.67% ($1,467 / $22,000 = 0.067 x 100). With an asset’s depreciation rate, you’ll be able to create a depreciation schedule to see how much value an asset loses each year.
The straight-line depreciation method is the easiest way of calculating depreciation and is used by accountants to compute the depreciation of long-term assets. However, this depreciation method isn’t always the most accurate, especially if an asset doesn’t have a set pattern of use over time. For example, technology is rapidly evolving. This means items like computers and tablets often depreciate much quicker in their early useful life while tapering off later on in their useful life.
As a small business owner, you have to keep track of the value of your assets. Doing so can help you save money through taxes, produce accurate financial statements like your balance sheet, and manage cash flow each accounting period. With QuickBooks Accounting, you can keep all of your business finances in one place, making money management easier than ever.
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