Straight-line Method of Depreciation
In the straight-line depreciation method, the cost of a fixed asset is reduced equally in each period of its useful life till it reaches its residual value.
If we plot the depreciation expense under the straight-line method against time, we will get a straight line. Depending on the frequency of depreciation calculation, the carrying amount of the asset declines in equal steps.
Due to its simplicity, the straight-line method is the most common depreciation method. As the purpose of depreciation is to write off the cost of an asset as it generates economic benefits, the straight-line method is theoretically correct because many assets are equally productive in each period of their useful lives. Where an asset’s productivity declines over time, it might be more appropriate to use any accelerated depreciation methods.
The annual depreciation rate under the straight-line method equals 1 divided by the useful life in years.
|Annual straight-line depreciation rate =||1|
|Useful life in years|
In the straight-line method, depreciation expense for a period is calculated by multiplying the depreciable amount (the difference between cost and residual/salvage value) with the annual depreciation rate and a time factor.
Alternatively, depreciation expense for a period can be calculated by dividing the depreciable amount by the number of time periods. The depreciation expense worked out under this method would always correspond to the time unit used for expressing useful life, i.e. useful life in months must be used to work out monthly depreciation.
|Straight-line depreciation expense =||Cost − Residual value|
Cost is the amount at which the fixed asset is capitalized initially in the balance sheet on its acquisition. Residual value (also called salvage value) is the estimated value of the fixed asset at the end of its useful life. Since an amount equal to the residual value can be recovered by selling the asset or from its alternative use, only the difference between the cost and the residual value is depreciated. Useful life of a fixed asset represents the number of accounting periods within which the asset is expected to generate economic benefits.
As purchase of fixed assets does not normally coincide with the start of the financial year, companies must make a decide when to start/cease depreciation. Some companies elect to charge the whole-month depreciation in the income statement in the month of purchase and do not charge any depreciation expense in the month of disposal, and vice versa.
Depreciation expense can be recorded using the following journal entry:
The credit is always made to the accumulated depreciation, and not to the cost account directly.
Straight-line depreciation can also be calculated using Microsoft Excel SLN function.
Example 1: Whole-period depreciation in the period of purchase
On 1 July 20X1, Company A purchased a vehicle at a cost of $20,000. The company expects the vehicle to be equally useful for 4 years after which it can be sold for $5,000. Calculate depreciation expense for the financial years ended 31 Dec 20X1, 20X2, 20X3 and 20X4.
The depreciable amount of the vehicle is $15,000 ($20,000 cost minus $5,000 residual value) and useful life is 4 years.
Depreciation expense for the year ended 31 Dec 20X1 = $15,000 ÷ 4 = $3,750 per year.
Depreciation expense shall remain the same over the useful life. Hence, an amount of $3,750 shall be the depreciation expense for years ended 31 Dec 20X2, 20X3 and 20X4.
Even though the asset was bought mid-year, full year depreciation expense is charged in 20X1 and no depreciation expense shall be charged in 20X5 because the asset would be fully depreciated by the end of 20X4.
Example 2: Proportional depreciation
If Company A (in the scenario discussed above) had a policy of charging proportional depreciation expense in the years of purchase and disposal, the total depreciation expense shall remain the same, but the period-wise allocation would be different.
Under this scenario, the vehicle is used only for 6 months in the financial year ended 30 June 20X1. Proportional depreciation expense is calculated by multiplying the full year straight line depreciation expense by a fraction representing the part of the financial year during which the asset was used.
Depreciation expense for year ended 30 June 20X1 = [ ($20,000 − $5,000) ÷ 4 ] × 6/12 = $1,875
Full-year depreciation shall be charged in the financial years ended 30 June 20X2, 20X3 and 20X4, and partial depreciation expense shall be charged in the year of disposal i.e. financial year ended 30 June 20X5.
Presentation in income statement and balance sheet
|Year ended 20X1-06-30||1,875||18,125|
|Year ended 20X2-06-30||3,750||14,375|
|Year ended 20X3-06-30||3,750||10,625|
|Year ended 20X4-06-30||3,750||6,875|
|Year ended 20X5-06-30||1,875||5,000|
Please note that the carrying amount of the asset will never fall below the residual value because this is the amount which can be recovered even when the asset is no longer being used.