How to Use the Straight Line Depreciation Method in Accounting

Hey there! Welcome to Accounting Stuff, where I’m James and I’m here to help you learn how to calculate Straight Line Depreciation in three easy steps. In this video, we’ll cover the basics of depreciation and how it applies to tangible fixed assets, specifically on a farm. We’ll then dive into a full example where you’ll learn how to apply the Straight Line Method step-by-step. Straight Line Depreciation is the simplest way to depreciate tangible fixed assets, and in this mini-series on Depreciation in Accounting, we’ll explore other methods as well. So, let’s jump right in and get started!

Depreciation is the process of reducing the book value of a tangible fixed asset due to wear and tear, the passing of time, or obsolescence. Straight-line depreciation, our focus in this video, is a fixed cost method where the expense is spread out evenly over the asset’s useful life. To illustrate how this works, let’s imagine you’re a farmer and own a combine harvester. It initially cost you $450,000, and you expect to use it for twelve years before selling it for scrap at an estimated value of $90,000. Using the Straight Line Method, we’ll walk you through three simple steps to calculate the depreciation expense, accumulated depreciation, and book values. So, grab a calculator and let’s get started on this depreciation journey!

What is Straight Line Depreciation?

Definition of straight line depreciation

Straight line depreciation is a method of allocating the cost of a tangible fixed asset evenly over its useful life. This is done by subtracting the asset’s residual value from its initial cost and spreading the resulting value over the number of years the asset is expected to be used. The main characteristic of straight line depreciation is that the same depreciation expense is recognized each year, making it a simple and straightforward method.

Explanation of how it differs from other depreciation methods

Straight line depreciation differs from other depreciation methods, such as double-declining balance, sum of the year’s digits, and units of production, in its calculation and allocation of depreciation expense over time. While other methods may result in higher depreciation expenses in earlier periods and lower expenses in later periods, straight line depreciation spreads the cost evenly. This provides a predictable and consistent expense recognition pattern that can make financial planning and forecasting easier.

Example of Straight Line Depreciation

Introduction to the example

To illustrate the concept of straight line depreciation, let’s consider the example of a combine harvester used by a farmer. The combine harvester was purchased for $450,000, has an estimated useful life of 12 years, and is expected to have a residual value of $90,000 at the end of its useful life.

Step 1: Write down what you know

In this step, you need to identify the asset to be depreciated, choose the straight line depreciation method, determine the asset cost, estimate the residual value, and determine the useful life of the asset. In our example, the asset is a combine harvester, the straight line depreciation method is chosen, the asset cost is $450,000, the residual value is $90,000, and the useful life is 12 years.

Step 2: Build a depreciation schedule

A depreciation schedule is a table that tracks the depreciation expense, accumulated depreciation, and book values of the asset over time. In this step, you will set up the columns in the schedule, fill in the opening book value for year 1, calculate the depreciation expense for year 1, calculate the accumulated depreciation for year 1, and calculate the closing book value for year 1. Then, you repeat this process for subsequent years.

Step 3: Calculate the depreciation expense, accumulated depreciation, and book values

In this step, you calculate the depreciation expense, accumulated depreciation, and closing book value for each period. For straight line depreciation, the depreciation expense can be calculated by taking the straight line depreciation rate (which is 1 divided by the useful life of the asset) and multiplying it by the depreciable cost (which is the asset cost minus the residual value). The accumulated depreciation is the cumulative total of all depreciation expenses incurred, and the closing book value is the carrying amount of the asset at the end of the year.

Explanation of Depreciation Schedule

Definition of a depreciation schedule

A depreciation schedule is a table that provides a systematic breakdown of the depreciation expense, accumulated depreciation, and book values of a fixed asset over its useful life. It helps track the changes in value of the asset over time and provides valuable information for financial reporting and decision-making purposes.

Explanation of each column in a depreciation schedule

• Year: This represents the accounting period or year for which the depreciation is being calculated.
• Opening Book Value: This is the carrying amount of the asset at the start of the year, which is the same as the closing book value of the previous year.
• Depreciation Expense: This is the value that is written off as an expense on the income statement during the year.
• Accumulated Depreciation: This column represents the cumulative total of all depreciation expenses incurred from the start of the asset’s useful life up to the current year.
• Closing Book Value: This is the carrying amount of the asset at the end of the year, which is calculated by subtracting the depreciation expense from the opening book value.

Step 1: Write down what you know

Identifying the asset to be depreciated

In this step, you need to identify the specific tangible fixed asset that you will be depreciating. For example, in our example, the asset is a combine harvester.

Choosing the straight line depreciation method

The straight line depreciation method is chosen when the expense is spread out evenly over the asset’s useful life. It provides a predictable and consistent depreciation expense recognition pattern.

Determining the asset cost

The asset cost refers to the initial cost of the asset, which includes all costs incurred to acquire and put the asset into use. In our example, the combine harvester cost $450,000.

Estimating the residual value

The residual value, also known as the salvage value, is the estimated value the asset will have at the end of its useful life. It represents the amount that could be obtained from selling the asset after deducting any selling costs. In our example, the residual value of the combine harvester is estimated to be $90,000.

Determining the useful life of the asset

The useful life of an asset is the estimated period over which the asset is expected to generate economic benefits for the company. It is based on factors such as physical wear and tear, technological obsolescence, and legal or contractual limits. In our example, the combine harvester has a useful life of 12 years.

Step 2: Build a depreciation schedule

Understanding the purpose of a depreciation schedule

A depreciation schedule is a tool used to track and record the depreciation expense, accumulated depreciation, and book values of an asset over its useful life. It provides a clear and organized overview of the changes in value of the asset, making it easier for financial reporting and decision-making purposes.

Setting up the columns in the schedule

A depreciation schedule typically includes columns for the year, opening book value, depreciation expense, accumulated depreciation, and closing book value. Each column serves a specific purpose in tracking the changes in value of the asset over time.

Filling in the opening book value for year 1

The opening book value for year 1 is the carrying amount of the asset at the start of the year. In our example, the opening book value for year 1 would be the asset cost of $450,000.

Calculating the depreciation expense for year 1

The depreciation expense for year 1 can be calculated by taking the straight line depreciation rate (which is 1 divided by the useful life of the asset) and multiplying it by the depreciable cost (which is the asset cost minus the residual value). In our example, the straight line depreciation rate is 1/12 or 8.33% and the depreciable cost is $360,000. Therefore, the depreciation expense for year 1 would be $30,000.

Calculating the accumulated depreciation for year 1

The accumulated depreciation for year 1 is the cumulative total of all depreciation expenses incurred from the start of the asset’s useful life up to the current year. In our example, the accumulated depreciation for year 1 would be $30,000, which is the same as the depreciation expense for year 1.

Calculating the closing book value for year 1

The closing book value for year 1 is the carrying amount of the asset at the end of the year, which is calculated by subtracting the depreciation expense from the opening book value. In our example, the closing book value for year 1 would be $420,000 ($450,000 – $30,000).

Repeating the process for subsequent years

For the remaining years of the asset’s useful life, you need to repeat the process by using the closing book value of the previous year as the opening book value of the current year. You then calculate the depreciation expense, accumulated depreciation, and closing book value for each year until you reach the end of the asset’s useful life.

Step 3: Calculate the depreciation expense, accumulated depreciation, and book values

Explanation of depreciation expense calculation

The depreciation expense for each period can be calculated using the straight line depreciation rate and the depreciable cost. The straight line depreciation rate is obtained by dividing 1 by the useful life of the asset, and the depreciable cost is the difference between the asset cost and the residual value. By multiplying the straight line depreciation rate by the depreciable cost, you can determine the depreciation expense for each period.

Explanation of accumulated depreciation calculation

The accumulated depreciation is the cumulative total of all depreciation expenses incurred from the start of the asset’s useful life up to the current year. It represents the total amount that has been recognized as an expense for the asset’s depreciation over time. Each year, the depreciation expense is added to the accumulated depreciation to determine the cumulative total.

Explanation of closing book value calculation

The closing book value is the carrying amount of the asset at the end of the year. It is calculated by subtracting the depreciation expense for the year from the opening book value. The closing book value represents the net value of the asset after accounting for the accumulated depreciation.

Depreciation Graph

Introduction to the depreciation graph

A depreciation graph is a visual representation of how the book value of an asset changes over time as depreciation is recognized. It helps to illustrate the decrease in value of the asset and provides a clear picture of the asset’s depreciation process.

Explanation of the variables on the graph

The depreciation graph typically includes variables such as the year, the opening book value, the depreciation expense, the accumulated depreciation, and the closing book value. These variables are plotted on a graph to show the changes in the asset’s book value over time.

Illustration of how the book value changes over time

Using the example of the combine harvester, the depreciation graph would show the decrease in the asset’s book value over the 12-year period. The opening book value would start at $450,000, and each year, the depreciation expense would be deducted to calculate the closing book value. The graph would show a downward trend in the book value, with the closing book value reaching $90,000 at the end of the asset’s useful life.

Comparison to Other Depreciation Methods

Explanation of variable depreciation methods

Variable depreciation methods, such as the double-declining balance, sum of the year’s digits, and units of production methods, differ from straight line depreciation in their calculation and allocation of depreciation expense. These methods result in higher depreciation expenses in earlier years and lower expenses in later years, reflecting the pattern of asset usage or obsolescence.

Advantages and disadvantages of straight line depreciation method

The straight line depreciation method has several advantages, including its simplicity and consistency in recognizing an equal amount of depreciation expense each year. It is also easy to understand and apply, making it suitable for financial planning and forecasting. However, a disadvantage of straight line depreciation is that it may not accurately reflect the actual usage or obsolescence of the asset, especially if the asset’s value declines more rapidly in earlier years.

Conclusion

Summary of the straight line depreciation method

Straight line depreciation is a simple and straightforward method of allocating the cost of a tangible fixed asset evenly over its useful life. It provides a predictable and consistent pattern of depreciation expense recognition, making it easy for financial planning and reporting purposes.

Importance of proper asset depreciation in accounting

Proper asset depreciation is crucial in accounting as it reflects the reduction in value of fixed assets over time. Accurately calculating and recording depreciation expenses and maintaining depreciation schedules allows businesses to track the changing value of their assets and make informed financial decisions. It also ensures compliance with accounting standards and provides reliable financial statements.

Encouragement to learn about other depreciation methods

While straight line depreciation is the simplest method, it’s important to explore and understand other depreciation methods, such as double-declining balance, sum of the year’s digits, and units of production. Each method has its own advantages and disadvantages and may be more suitable for certain types of assets or industries. By familiarizing yourself with different depreciation methods, you can make informed decisions and choose the most appropriate method for your specific circumstances.