Calculating Profits and Losses with Straight Line Depreciation
Straight line depreciation deals with items which have a predictable useful period and lose value over that specific timeframe. For example, machinery, which can be a major expense, is also finite in usefulness. Perhaps it eventually fails due to normal wear and tear or even because new technology makes it obsolete. This would be a prime candidate for using straight line depreciation and this method of accounting is tax deductible as a business expense.
Example of Simple Straight Line Depreciation
Take for example an asphalt shingle roof which costs $10,000 and has a life expectancy of 30 years. When it is 15 years old it is destroyed by winds. Unfortunately, insurance will only pay $5000 toward the replacement costs since it is at the halfway point of its life expectancy. In other words, it has depreciated by 50%. The percentage of depreciation is determined by dividing the number of years the item is expected to last into the current age of the item. Fifty percent of $10,000 is $5000 which is deducted from the original cost to reach the actual cash value.
Although cars and machinery have a predictable rate of depreciation, they do not always depreciate at the same rate every year. In most cases, new cars have a greater rate of depreciation in the first year than they do in subsequent years. Even though these items may lose most of their value, they reach a point where they have scrap or salvage value and no longer depreciate. The percentage of depreciation decreases each year until the items reach salvage value.
Calculating Straight Line Depreciation
To calculate straight line depreciation the anticipated salvage value of the item is deducted from the original cost. The number of years the item is expected to be useful is assigned, for example, a PC is expected to be used for five years. The cost of the PC is $1600 and the anticipated salvage value is $100 leaving $1500 in depreciation over five years or a depreciation rate of $300 per year. Unfortunately, this method of depreciation may not be accurate for determining the actual cash value of assets but it does make accounting much easier.
Depreciation and Actual Cash Value
The actual cash value of an asset is considered to be the original cost less depreciation. However, the true actual cash value is the amount the item would bring if sold. In the above example, it is unlikely that a one year old computer would sell for $1300, so straight line depreciation gives an inflated cash value to the asset. If a business has 10 computers valued at $1300 each but the sale value is $1000 per computer, the value of the business’ assets is inflated by $3000.
The Advantages of Different Methods of Depreciation
Businesses which use accelerated depreciation generally have a more accurate valuation of assets than those which use straight line depreciation. Accelerated depreciation means lower reported income in the early years of an asset's life. Straight line depreciation may present an inflated valuation of business assets which can be useful in attracting investors or securing loans. Both methods of determining the value of assets are accepted as standard business practice.
Although straight line depreciation may not provide an accurate assessment of all business assets, it can have advantages for a business. For instance, it allows for a greater reported income shortly after the purchase of assets. Eventually, all methods of depreciation reach the point where the asset has only salvage value so the method which allows the greatest advantage to the business is the best method of depreciation for that particular company.