Straight Line Basis

The simplest way to calculate the loss of value of an asset over time

Depreciation and amortization are calculated on a straight-line basis. It is the simplest way to calculate the loss of value of an asset over time. 

Straight Line Basis

It is also known as straight-line depreciation. The straight-line basis is calculated by dividing the difference between the cost of an asset and its expected salvage value by the number of years it is expected to be used.

Numerous accounting conventions are designed to match sales and expenses to the period in which they are incurred. Depreciation and amortization is one convention that businesses follow.

Depreciation is used for physical assets, while amortization is used for intangible assets such as patents and software. Both conventions are used to expense an asset over time rather than just when it was purchased. 

In other words, businesses can spread the cost of assets over various periods, allowing them to benefit from the asset without deducting the full cost from net income (NI).

Straight line basis calculation

The straight-line basis is a method for calculating an asset's value reduction rate over its useful life. Other common methods for calculating fixed asset depreciation expenses include the sum of the year's digits, double-declining balance, and units produced.

Chart Analysis

To calculate a straight line basis, start with the asset's purchase price and subtract the salvage value or its estimated sell-on value when it is no longer expected to be needed. Then divide the result by the total years the asset is expected to be useful, referred to in accounting as the useful life.

Straight Line Basis = (Purchase Price of Asset - Salvage Value) / Estimated Useful Life of Asset

Straight Line Basis Illustration

Assume Company A spent $10,000 on a piece of equipment. The equipment has a 10-year expected life and a salvage value of $500. 

The accountant divides the difference between the salvage value and the cost of the equipment (also known as the depreciable base or asset cost) by the expected life of the equipment to calculate straight-line depreciation.

This piece of equipment's straight-line depreciation is ($10,500 - $500) / 10 = $1,000. This means that instead of deducting the entire cost of the equipment in the current period, the company will only have to deduct $1,000. 

The company will continue to expense $1,000 to a contra account, known as accumulated depreciation until the equipment is valued at $500.

Advantages and disadvantages

Accountants prefer the straight-line method because it is simple to apply, produces fewer errors over the asset's life, and incurs the same expense each accounting period

In contrast to more complex methodologies such as double declining balance, a straight line is straightforward and uses only three variables to calculate the amount of depreciation each accounting period.

However, one of the main disadvantages of a straight-line basis is its simplicity. One of the most obvious drawbacks of this method is that the useful life calculation is based on conjecture. 

For example, there is always the possibility that technological advancements will render the asset obsolete sooner than expected.

Exchange

Furthermore, the straight-line basis ignores the accelerated loss of an asset's value in the short term and the likelihood that it will cost more to maintain as it ages.

The straight-line basis is a method for calculating an asset's value reduction rate over its useful life. Other common methods for calculating fixed asset depreciation expenses include the sum of year's digits, double-declining balance, and units produced.

Companies use depreciation and amortization to achieve the matching objective. Intangible assets are only amortized if their useful life is limited. Fixed and intangible assets, such as software and patents, are also amortized on a straight-line basis. 

Fixed asset depreciation is similar to amortization in that both use a straight-line basis to calculate the expense amount.

The straight-line basis method is used by businesses to determine the amount to be expensed over accounting periods. To calculate an asset's depreciation, subtract the salvage value from the purchase price and divide the difference by the asset's estimated useful years.

Practical Example

Assume that Company X spends $20,500 on a new asset. The asset has a life expectancy of 20 years and an estimated salvage value of $1,500. First, the difference between the asset's purchase price and the salvage value is calculated.

This distinction is sometimes referred to as the depreciable base. The difference is then divided by the asset's expected life to determine the annual depreciation expense amount. The straight line depreciation of the asset is:

Depreciable Base = $20,500-$1,500=$19,000

Straight Line Depreciation=$19,000/20=$950

Thus, instead of writing off the full cost of the asset in the current accounting period, as would happen under the cash basis of accounting, Company X only needs to expense $950. Furthermore, the company will continue to expense $950 per year until the asset's book value reaches the salvage value of $1,500.

Pie Chart

Straight-line depreciation calculation requirements

Straight-line depreciation for a fixed asset requires three numbers:

  • The asset's total purchase price (the asset's cost including shipping, taxes, installation fees, etc.)

  • The asset's scrap or salvage value-the price you believe you can sell it for at the end of its useful life

  • The asset's useful life-how many years you expect it to last

  • To calculate your asset's straight-line depreciation rate, subtract the salvage value from the asset cost to get total depreciation, then divide that by useful life to get annual depreciation:

(purchase price - salvage value) / useful life = annual depreciation

Bar and Pie Chart

According to straight-line depreciation, we must subtract an asset's value each year to determine its book value. The total value of an asset after depreciation up to the current point in time is referred to as book value.

A word about useful life: if you're calculating depreciation for tax purposes, you should use the IRS's useful life figure, which has classified most depreciable assets into one of seven "property classes."

In practice, straight-line depreciation

Let's say your company spends $2,000 on a MacBook that won't be useful in five years and has a $500 estimated salvage value (how much you think you can sell it for in five years). (The IRS requires you to depreciate computers over five years.)

To calculate straight-line depreciation for the MacBook, you must do the following:

Depreciation per year = ($2000 - $500) / 5 years

= $1,500 / 5 years

= $300

Your MacBook will depreciate $300 per year based on straight-line depreciation.

What distinguishes straight-line depreciation from other methods?

Things wear out at different rates, necessitating different depreciation methods, such as the double declining balance method, the sum of years method, or the unit-of-production method.

  • Straight line depreciation is by far the simplest of the three methods

  • Consider how much the MacBook in the preceding example depreciates each year based on straight-line depreciation:

Depreciation in the first year: $300

Depreciation in Year 2: $300

Depreciation in year three: $300

Depreciation in year four: $300

Depreciation in Year 5: $300

Now consider how much that same MacBook would depreciate if the double declining balance and the sum of years methods were used:

Double declining balance and sum of years methods
Double declining methodSum of years method
Year 1 depreciation: $800Year 1 depreciation: $500
Year 2 depreciation: $480Year 2 depreciation: $400
Year 3 depreciation: $220Year 3 depreciation: $300
Year 4 depreciation: $0Year 4 depreciation: $200
Year 5 depreciation: $0Year 5 depreciation: $100

 

Take note of how both of these methods apply more depreciation at the beginning of an asset's life than at the end. This can be more accurate and useful. (Most tangible assets, such as computers, automobiles, and machinery, lose most of their value in the first few years of use.)

The unit-of-production method is similar to straight-line depreciation, except that it measures depreciation in production units rather than dollars.

The number of labels printed by a label printing machine, miles driven by a vehicle, or kilowatt hours produced by a power plant is examples of production units.

You'll need two more pieces of information to calculate depreciation using the unit-of-production method:

  • The number of units produced by an asset that year

  • The total number of units you anticipate it will produce during its lifetime.

Enter these figures into the following equation to calculate the total depreciation of your asset in units:

Phone

The number of labels printed by a label printing machine, miles driven by a vehicle, or kilowatt hours produced by a power plant is examples of production units.

You'll need two more pieces of information to calculate depreciation using the unit-of-production method:

  • The number of units produced by an asset that year

  • The total number of units you anticipate it will produce during its lifetime.

Enter these figures into the following equation to calculate the total depreciation of your asset in units:

Notes

Annual depreciation in terms of number of units =

(purchase price minus salvage value) x (number of units manufactured that year) / total number of units expected over lifetime

This method is best suited for equipment and tools that degrade with use-as they produce a certain number of units, travel a certain number of miles, generate a certain amount of electricity, and so on rather than over time.

When is the straight-line method appropriate?

  • Certain expenses can be deducted from your financial statements

  • Depreciation is a business expense, just like any other. As a result, you must ensure that you calculate depreciation correctly

Most businesses use straight-line depreciation for their books, but some use the double declining or sum of years method, which results in more write-offs near the beginning of an asset's life.

Computer

The IRS has a specific depreciation method known as the Modified Accelerated Cost Recovery System, or MACRS, for tax purposes. In some cases, the IRS may even allow you to deduct the full cost of certain assets (such as computers, software, and office furniture) during their first year of use, eliminating the need for depreciation methods entirely.

However, the IRS uses the accelerated/MACRS or Section 179 method for certain assets, including intangible assets such as copyright, patents, and trademarks. So instead, you use amortization for those.

What role does straight-line depreciation play in my accounting?

Assume you're using straight-line depreciation to calculate the monthly depreciation expense for all of your company's assets. You calculate the total depreciation for all your assets that month to be $250. So, what do you do now?

In this case, you would record the following in your books:

Example
 DebitCredit
Depreciation expense$250 
Accumulated depreciation $250

 

You would deduct a $250 depreciation expense for that month, which would appear on your income statement. (On financial statements, depreciation expenses are classified as "operating expenses.")

Data

You would also credit an accumulated depreciation account, which is a type of asset account. These accounts have a credit balance (when an asset has a credit balance, it is equivalent to having a 'negative' balance), which means they reduce the value of your assets as they increase in value.

What are Different Types of Depreciation?

While there are several methods for calculating depreciation, three are the most commonly used.

  1. Straight Line

  2. Double Decline Balance

  3. Unit of Production Method

Double Decline Balance: This method uses an accelerated depreciation technique to reduce tax exposure. Depreciation costs are written off much more quickly in this case. This technique is used when a company uses an asset in its early years because the asset is more likely to provide better utility during these years.

This method allows businesses to expense twice the asset's book value each year.

Double Declining Method Formula:

Depreciation Expense = 2 * Straight Line Depreciation % * Book Value at the Beginning of the Period

Book value = Asset price - accumulated depreciation

Method of Production Unit: This method consists of two steps.

  • Depreciation calculated per unit

  • Calculating the total depreciation of all units manufactured

Because equal expenses are allocated to each unit, the calculation is based on the asset's output capability rather than time in years.

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Researched and authored by Javed Saifi | Linkedin

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