If you’re already familiar with appreciation — namely the increase in the value of an asset over time — then the concept of depreciation should be simple to understand. It’s the opposite of appreciation: an asset’s loss of value over time.
Specifically, it is defined as the diminishing value of a business asset over the course of the usefulness of its life.
There are multiple methods of calculating depreciation, but the simplest and most often-used formula is the straight-line method of depreciation.
What Is Straight-Line Depreciation?
It’s important to understand which types of assets depreciate and which appreciate.
Stocks, bonds, some real estate, and even currencies tend to appreciate over time. Other types of assets, especially tangible assets that you can physically touch and use, lose their value as they cease to be useful and relevant. These are sometimes referred to as “plant assets.”
If your business purchases a new computer system, its value and usefulness is guaranteed to depreciate.
Continued use of the system could cause it to slow down or degrade, but more importantly, new and improved computer systems will emerge on the market and render your original system obsolete.
With straight-line depreciation, the value of an asset is reduced at a steady rate over each period until it reaches its salvage value — or the amount for which it can be exchanged when it has reached the end of its usefulness. Salvage value is sometimes referred to as “residual value” in accounting.
Once calculated, straight-line depreciation can be represented using a simple line graph that includes a straight line, trending downward in value (y) over time (x), hence the term straight-line depreciation.
Straight-line depreciation is generally considered the default method for calculating the depreciation of assets. Other methods, such as double-declining balance and units-of-production depreciation, can be applied to relevant assets and situations.
Double-declining balance is an accelerated depreciation method that results in a high depreciation expense in the first year, followed by gradually decreasing depreciation expenses in subsequent years.
If a company purchases a new machine for their plant, they may expect the utility of this asset to be consumed more rapidly at the beginning part of its useful life, then gradually decrease over time. This is a situation where double-declining balance may apply.
When to Use Straight-Line Depreciation
While straight-line depreciation is useful when determining the lifetime value of business assets, it is also important to apply it to your tax calculations so you can maximize deductions and to your bookkeeping, so you can keep your accounting books clean and accurate.
When you purchase an asset, you can’t typically write off the entire cost on your taxes in the year you purchased it. Instead, the Internal Revenue Service (IRS) lets you deduct a portion of the cost each year over the course of the asset’s useful life.
The straight-line depreciation formula will give you the same tax deduction for an asset, year after year, over the course of the asset’s useful life. This works differently than other depreciation methods that provide differing tax deductions each year.
The method you use will depend on the asset in question. According to IRS Publication 946 concerning how to depreciate property, most farm property falls under the 150% declining balance method, whereas most real property falls under the straight-line method.
Because it is the easiest depreciation method to calculate, straight-line depreciation tends to result in the fewest number of accounting errors. It’s best applied when there is no apparent pattern to how an asset will be used over time. Office furniture, for example, is an appropriate asset for straight-line depreciation.
Using this method in your books enables you to account for the same amount of money being taken as a depreciable business expense each year. You’ll have a better chance of keeping your accounting books clean and less chance of missing out on tax opportunities when it comes time to submit your business expenses to the IRS.
How to Calculate Straight-Line Depreciation
Calculating straight-line depreciation is the easiest way to assess the depreciation of an asset. The variables you need to input are:
- The asset’s initial cost (cost basis)
- The value of the asset at the end of its life (salvage value)
- The asset’s useful lifespan in years
Then, you simply input the variables into the formula.
The formula for the straight-line depreciation of an asset is:
Straight-Line Depreciation = (Cost Basis – Salvage Value) / Useful Lifespan
If you purchase an asset for $3,000 and it has an approximate salvage value of $300 after 3 years, the calculation would look like this:
- ($3,000 – $300) / 3 years
- $2,700 / 3 Years
- $900 annual straight-line depreciation
Your asset will depreciate by about $900 each year until it reaches the end of its lifespan, at which time it will be at its salvage value of $300.
Of course, getting the numbers to replace these variables is part of the calculation. You can estimate based on your previous experience or you can conduct research to learn about standard useful lifespans, salvage values, etc. Here is a breakdown of the variables you need for this calculation.
Cost Basis of the Asset
The cost basis is the original value of your asset for tax purposes. It usually coincides with the asset’s purchase price. This is relatively easy to identify in physical assets you’ve purchased, but it can be a bit more complicated for other types of assets.
For investments, the cost basis of the asset is usually the total amount you originally invested in the asset plus any commissions, fees or other expenditures involved in the purchase. For tax purposes, it’s important to note if you reinvested any dividends and capital gains distributions rather than taking those distributions in cash. These reinvestments increase the tax basis of your investment. If you don’t account for them, you could end up paying more taxes.
The salvage value is the total value of the asset when it reaches the end of its useful life. Going back to the example of the computer system, the salvage value would be the amount you could sell it for once you’re finished using it.
If your asset depreciates too much, it could reach a salvage value of $0. You can still use this amount in your straight-line depreciation equation. You may wish to allow your asset to depreciate if it is still useful despite its lack of monetary value.
Estimated Useful Life
For accounting purposes, the useful life of an asset is the number of years it can continue to contribute to revenue generation while being cost-effective.
The IRS has a useful system known as the Modified Accelerated Cost Recovery System (MACRS), which is sometimes represented as a table.
You can use this table as a reference to understand the estimated useful lifespans of specific types of assets, especially plant assets.