All businesses require some sort of machinery or equipment or any other physical asset that helps them to generate revenue. These physical assets or tangible assets wear out after a point in time. For any business to arrive at a conclusive and authentic accounting report, it is important to value these tangible assets, while taking into account the drop in asset value. Straight line depreciation is such a method of depreciation calculation.
Through this post, we shall learn about:
- The concept of depreciation and its types in detail
- Straight line depreciation
- Formula and calculation along with examples of depreciation
- Journal entries for the Straight Line depreciation
What is Depreciation?
Depreciation refers to the method of accounting which allocates a tangible asset's cost over its useful life or life expectancy. Depreciation is a measure of how much of an asset's value has been depleted over the depreciation schedule or period.
Depreciating assets, including fixed assets, allows businesses to generate revenue while expensing a portion of the asset's cost each year it has been used. It can have a significant impact on profits if not taken into account.
Businesses can recoup the cost of an asset at the time it was purchased by calculating depreciation. The process enables businesses to recover the cumulative cost of an asset over its life rather than just the purchase price. This also enables them to substitute future assets with an adequate amount of revenue.
More on Depreciation
Depreciation is a method that allows the companies to spread out or distribute the cost of the asset across the years of its use and generate revenue from it. The threshold amounts for calculating depreciation varies from company to company.
While paying for an asset, the payment may have been done outright. However, the expenditure will be recorded in an incremental manner for reporting. This is done as the companies use the assets for a long time and benefit from using them for a long period. Therefore, although depreciation does not exhibit an actual outflow of cash but is still calculated as it reduces companies’ income; which needs to be estimated for tax purposes.
Example of Depreciation:
A company buys a piece of equipment worth $ 10,000 with an expected usage of 5 years. Then the enterprise is likely to depreciate it under the depreciation expense of $2000 every year over the 5 years of its use. This will also be recorded as accumulated depreciation on the balance sheet.
What are Different Types of Depreciation?
While there are various methods to calculate depreciation, three of them are more commonly used.
- Straight Line
- Double Decline Balance
- Unit of Production method
Being the simplest method, it allocates an even rate of depreciation every year on the useful life of the asset. It estimates the asset’s useful life (in years) and its salvage value at the end of its term. Subtracting the salvage value from the original price of the asset gives us the final depreciation amount that is to be expensed.
Formula for Straight Line Depreciation
Double Declining Balance Depreciation
For minimizing the tax exposure, this method adopts an accelerated depreciation technique. Here, the depreciation costs are written off much rapidly. This technique is used when the companies utilize the asset in its initial years as the asset is more likely to provide better utility in these years.
In this method, the companies expense twice the amount of the book value of the asset each year.
Formula for Double Declining Method
Unit of Production Method
This method comprises two steps.
- Calculating per unit depreciation
- Calculating total depreciation of all units produced
Equal expenses are allocated to every unit and therefore, the calculation is done based on the output capability of the asset instead of the time in years.
Formula for Unit of Production Method
Step 1: Calculation for depreciation per unit
Step 2: Calculation for a total depreciation of actual units
Of the three methods discussed, we shall closely go through the Straight-line depreciation method in the following sections.
What is Straight Line Depreciation?
As seen in the previous section, the straight-line depreciation method depreciates the value of an asset gradually, and linearly, over the years it is used. Here, each year will assign the same amount of percentage of the initial cost of the asset.
This method helps to estimate the overall consumption pattern of the asset. Owing to its ability to its simple presentation and reduced chances of errors, the method is highly recommended.
The following image is a graphical representation of the straight-line depreciation method.
With the help of this method, organizations can easily assess the consumption of the asset over the years.
In accounting, the straight-line depreciation is recorded as a credit to the accumulated depreciation account and as a debit for depreciating the expense account.
When is it Advised to Use Straight Line Depreciation?
Physical or the tangible assets get depreciated whereas intangible assets get amortized. While both the procedures are a way to write off an asset over time, the challenge lies in how to achieve that. Simply put, businesses can spread the cost of assets over a series of different periods, allowing them to benefit from the asset. Moreover, this can be accomplished without deducting the full cost from net income.
Most often, the straight-line method is preferred when it is not possible to gauge a specific pattern in which the asset depreciates. It is used when the companies find it difficult to detect a pattern in which the asset is being used over time.
The straight-line method is advised also because it presents calculation most simply. It has a straightforward formula and an approach that reduces the occurrences of errors. All these factors make it a highly recommended method for calculating depreciation.
What is the Straight Line Depreciation Formula?
Revisiting the formula of the Straight-line depreciation method, we shall also look into the steps of calculation.
Asset price is the purchase price of the asset.
Residual value is the salvage value or the value at the end of the life of the asset.
The useful life of the asset depicts the number of years for which it was in use.
Calculation Examples of Straight Line Depreciation (with and without salvage value)
Let’s look at two examples of straight-line depreciation. One with a non-zero salvage value (also known as scrap value or residual value) and the other without it.
Example of straight-line depreciation with salvage value:
Assume a manufacturing company purchases machinery worth $60,000.
Estimated Salvage value = $10,000
Useful life of the machines = 5 years
The calculation for the depreciation goes as:
Annual depreciation expense = 60,000 - 10,000 = 50,000
The company takes 50,000 as the depreciation expense every year for the next 5 years.
Applying the formula,
50,000 / 5 = 10,000
So, the manufacturing company will depreciate the machinery with the amount of $10,000 annually for 5 years.
Example of straight-line depreciation without the salvage value:
To illustrate this, we assume a company to have purchased equipment on January 1, 2014, for $15,000. Here, the company does not estimate a salvage value for the equipment. The useful life assumed is 5 years, that is till December 2019.
With a straight line depreciation method,
Salvage value = 0
Original price = 15,000
Depreciating amount each year = (15,000 - 0 )/ 5 = 3,000
However, the company realizes that the equipment will be useful only for 4 years instead of 5.
Now, the depreciating amount cannot be changed as it has been reported already. So, this change in the useful life only affects the depreciation reported for the last two years i.e. 2018 and 2019.
Let’s first see the straight-line depreciation presentation:
Now, let’s also consider the following T-accounts for the accumulated depreciation.
All the above calculation is representative of the book value of the equipment as $3,000. ($15,000-$12,000).
This also indicates that there are two years yet remaining to carry out the depreciation of $3,000.
So, 3000/2 =$1500 of depreciation expense in the final two years of 2018 and 2019.
Here are the adjusting double entries.
Now, the final sheet of accumulated depreciation will be:
Eventually, no previous recordings were changed even though the useful life expectancy changed and salvage value was unknown.
How does Straight Line Depreciation Affect Accounting?
Comprehending asset depreciation is a critical component of today’s economy. We know that asset depreciation applies to capital expenditures, or items of equipment or machinery that will be used to generate income for your organization over several years.
Depreciation is closely associated with accounting and accounting systems. As the straight-line method is a simple method that provides results in an expedited manner, it could be very beneficial for accountants and CPAs to gather data and calculate the wear and tear that has occurred to the equipment or assets.
We can sum up a few benefits of the straight-line method here:
- Reports accurate value: Straight-line method can derive authentic results in no time and will, therefore, be helpful for the business to move in the right direction by ensuring correct financial reporting.
- Improve budgeting: With the straight-line method providing accurate numbers, the managers will have all the data on their desks to plan and implement strategies to improve the budget and play an important part in management accounting.
- Reduce expenditure: The overall efficiency and output improves when the team can accurately determine the condition of the assets, thereby help in saving dollars.
- Comprehensive financial record: With accurate data for tracking the depreciation of assets at hand, the organization is likely to have a more holistic financial record. This would be specifically beneficial at the time of financial audits.
Therefore, we may safely say that the straight-line depreciation method helps in the process of accounting in more ways than one.
Which Financial and Accounting Reports does Depreciation Posting Impact?
Depreciation accounting necessarily involves a continuous succession of journal entries to charge a fixed asset to the expense and, eventually, to derecognize it. These double entries are intended to reflect the continuous use of fixed assets over time.
The purpose of using depreciation to gradually reduce the recorded cost of a fixed asset is to recognize a portion of the asset's expense at the same time the company records the fixed asset's revenue. The depreciation journal entry can be a simple entry that facilitates all types of fixed assets, or it can be broken down into separate entries for each type of tangible asset.
Effect on Financial Statements:
On balance sheet: A company uses cash to pay for an asset on the balance sheet, which initially results in asset transfer. Unlike cash, a fixed asset does not retain its value over time, and therefore, the carrying value must be gradually reduced. Depreciation expense gradually reduces the value of a fixed asset, allowing asset values to be properly represented on the balance sheet.
On income statements: Depreciation is typically shown as an indirect expense on the income statement. Just like other indirect expenses such as financial and marketing costs, it is an allowable expense that reduces a company's gross profit. Depreciation expenses can help a company with tax benefits because they can be deducted as an expense, lowering the company's taxable income by lowering net profit. This is advantageous because, in addition to maximizing profits, businesses want to minimize taxes.
What are the Journal Entries posted when a Straight Line Depreciation Entry is Made?
You can avoid incurring a large expense in a single accounting period by using depreciation, which can hurt both your balance sheet and your income statement.
Once depreciation has been calculated, the expense must be recorded as a journal entry. The journal entry would be used to record depreciation expenses for a specific accounting period and can be manually entered into a ledger.
The depreciation journal entry is an adjusting entry, which is the entries you'll make before running an adjusted trial balance. We need to ensure the creation of a contra asset account via the chart of accounts for accumulated depreciation before recording a journal entry. Depending on your current accounting method, you have two options when recording a journal entry with the credit and debit accounts.
This is how the depreciation journal entries look like:
The credit is made to the accumulated depreciation instead of the cost account.
Considering the values in the example above, the journal entries are as shown:
Doing asset depreciation manually, even for seasoned professionals, is prone to error. Using an online accounting system makes this task a lot easier.
The key points to take home with this post are:
- We saw that depreciation refers to the method of accounting which allocates a tangible asset's cost over its useful life.
- Straight line, Double Declining Balance, and Unit of Production are the three most commonly used methods to calculate depreciation.
- Companies mostly prefer the straight-line method due to its simplicity and near error-free results.
- Depreciation is categorized as a type of expense that is used to reduce an asset's carrying value.
- Companies use cash flow to pay for fixed assets that will be depreciated later.
- Depreciation is recorded as a debit-to-cost and an asset value credit so that actual cash flows do not change.
- Using an online accounting system like Deskera can automate asset depreciation calculation and posting.