Series: Capital Investments How to Calculate Straight-line Depreciation

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1 Series: Capital Investments How to Calculate Straight-line Table of Contents The Straight-Line Method... 2 An Example of How to Calculate Straight-line... 2 Practice How to Calculate Straight-line... 4 Summary... 5 Appendix A: An Example of a Completed Schedule... 6

2 How to Calculate Straight-line Page 2 The Straight-line Method The straight-line depreciation method is the method most commonly used when calculating depreciation expense for financial reporting purposes. It calculates the depreciation expense by dividing the total cost of the asset by its estimated useful life. The estimated useful life is the time-period we expect an asset to contribute to the operation of a business. It is related to the economic life of the asset or how long the asset will be used in income-generating activities. It does not necessarily reflect the physical life of the asset, which may be longer than the estimated useful life. The estimated useful life of an asset is usually set by company policy for different categories of assets. As a result, different categories of assets will have different useful lives. For example, a building may have an estimated useful life of 30 years; a machine may have approximately 7-15 years; and office equipment, 5-10 years. However, if you know the equipment will have a useful life lower than the one established by the company policy, it is important that you document the situation and notify Accounting immediately. Net book value is the difference between the cost of the asset and the accumulated depreciation at the end of the accounting period. Note that the net book value has no relation to the fair market value of an asset. An Example of How to Calculate Straight-line Let us illustrate the concept of depreciation with a simple example. Suppose your company purchased a vehicle for $30,000 with an estimated useful life of 5 years. Using the straight-line depreciation method, the depreciation expense is $6,000 per year. This amount is obtained by dividing the $30,000 acquisition cost by 5 years estimated useful life. expense per year = Acquisition cost Useful life $6,000 = $30,000 5 years Under the straight-line depreciation method, the depreciation amount will remain the same over the asset's useful life. In this example, the depreciation expense will be $6,000 per year for 5 years. We will use a depreciation schedule to walk you through our example. Most companies use some type of depreciation schedule to calculate and record depreciation for their fixed assets. This schedule can be automated or manual, depending on the size of the company and the number of fixed assets

3 How to Calculate Straight-line Page 3 on the books. A depreciation schedule includes the beginning balance or cost basis on the value of the asset, the accumulated depreciation at the start of the accounting period, the depreciation expense and the net book value at the end of the year For example for year 1, the cost basis is the total acquisition cost of $30,000. The cost basis will remain constant over the useful life of the asset unless the asset suffers a permanent decline in value, in which case it must be adjusted downward. The accumulated depreciation at the beginning of the period is 0 because this is the first period during which we will be charging depreciation to expense. The depreciation expense equals $6,000. The book value at the end of the accounting period is $24,000: the acquisition cost of $30,000 minus the depreciation expense of $6,000. During year 2, the cost basis is $30,000 and the accumulated depreciation is $6,000, which is the amount that was charged to income for Year 1. The depreciation expense for Year 2 is another $6,000 and the net book value equals $18,000, which we calculate by subtracting the accumulated depreciation and the depreciation expense for year 2 from the cost basis of $30,000. The accumulated depreciation at the end of the accounting period or beginning of the following period would equal $12,000.

4 How to Calculate Straight-line Page 4 2 $30,000 $6,000 $6,000 $18, Practice How to Calculate Straight-line Let us practice what you have learned. Give yourself a couple of minutes to complete the depreciation schedule for Year 3 through 5 in the space provided below. 2 $30,000 $6,000 $6,000 $18, The completed depreciation schedule is presented in Appendix A. After you have completed the depreciation schedule please refer to Appendix A. Note that at the end of the asset's useful life of 5 years, the net book value as reported in the balance sheet is $0. In other words, the asset has been fully depreciated and the depreciation expense will not be recorded in subsequent years, even if the asset remains in use. A fully depreciated asset may continue to be used in the business until physically scrapped or sold. As

5 How to Calculate Straight-line Page 5 previously mentioned, the physical life of an asset does not necessarily correspond to its useful life for accounting purposes. Summary The straight-line depreciation method calculates the depreciation expense by dividing the total cost of the asset by its estimated useful life. Using this method, the same amount of depreciation will be charged to expense each year of its useful life. At the end of the estimated useful life, the asset will be fully depreciated with a net book value of $0 in the balance sheet. expense will not be recorded in subsequent years, even if the asset remains in use. Because the physical life of an asset does not necessarily correspond to its useful life for accounting purposes, a fully depreciated asset may continue to be used in the business until physically scrapped or sold.

6 How to Calculate Straight-line Page 6 Appendix A: Example of a Completed Schedule 2 $30,000 $6,000 $6,000 $18,000 3 $30,000 $12,000 $6,000 $12,000 4 $30,000 $18,000 $6,000 $ 6,000 5 $30,000 $24,000 $6,000 $ 0