Being Aware of the Advantages and Disadvantages of Straight Line Depreciation
Straight line depreciation is one method of determining the value of business assets as they age. While it has some advantages, it may also have disadvantages, especially when reporting taxes. When money is spent to purchase an asset it is not recorded as an expense, rather the expense is spread over the useful life of the item as depreciation. This is what is known as straight line depreciation and it is the simplest method for expensing an asset.
How Straight Line Depreciation Is Calculated
The business accountant will take the initial cost of the item and then decide how long the item will be useful. He must also calculate whether the asset will have a salvage which is the remaining value at the end of its useful life for the business. The salvage value is deducted from the initial cost and the amount remaining is divided by the number of years the business expects to use the asset. That amount is deducted as an expense each year until the item reaches its salvage value.
Simple and Predictable
When seeking to understand the advantages and disadvantages of straight line depreciation, there are factors to consider which may be simple and predictable. One advantage is that the accountant knows exactly how much will be expensed on the item each year until it reaches the end of its useful life. When forecasting, the accountant does not have to spend time calculating the depreciation for each year since it will be the same amount. Unfortunately, there are some problems with using straight line depreciation to determine the worth of assets since the assets may not depreciate at the same rate every year.
Inflated Valuation of Assets
When straight line depreciation is used, an asset may have a lower cash value than the amount shown on the books. Many assets, like cars, lose more in depreciation in the first year than they do in subsequent years. If straight line depreciation is employed to estimate the value of a car, the actual resale value at the end of the first year will be lower than the figure which would be obtained when calculating with the straight line depreciation technique. On the other hand, the company's reported income will be higher than if the actual depreciation was used.
Taxes and Business Expenses
Depreciation is a business expense which may be deducted from taxes and straight line depreciation provides a fixed deduction for every year of an asset's useful life. Conversely, accelerated depreciation uses a decreasing scale to measure loss of value and at one time was used to provide a larger tax deduction in the early years of an asset's life with lower deductions each year. However, it is more difficult to make financial forecasts using accelerated depreciation and it results in a lower reported income during the first years of the asset's life.
In light of all this, the greatest advantage of straight line depreciation is that is a predictable expense spread over a number of years which simplifies financial forecasting. It also provides a way to show greater business income in the early part of the asset's life. The disadvantage is that assets are often shown with inflated values since the assets may have lost the greatest amount of value in the first year or two. While this may become an issue if the assets are being used to secure credit, in the end a decision will need to be made whether predictability in accounting or creditworthiness is the more important focus.