What Does Straight Line Depreciation Mean?

Key Takeaways

• Straight line depreciation is the simplest and most commonly used depreciation method for allocating a capital asset’s cost. 

• Compared with the depreciation method of double-declining balance — an accelerated depreciation approach — straight line depreciation is more user friendly.

• Straight line depreciation typically covers fixed assets such as real estate, equipment, and machinery, as they are expected to last more than one year.

As an accounting process, depreciation spreads a fixed asset’s cost over its useful life, or the period in which it will likely be used. 

The company can, during this period, write off the asset’s value. The assets are commonly equipment, machinery, or property. Writing off just a portion of the cost each year allows investors to report more net income than they otherwise would have.

Depreciation is used by companies to transfer asset costs from balance sheets to income statements. A number of methods can be used, including straight line depreciation. 

Here is what investors and prospective investors should know about straight line depreciation, which can help with investment decisions.

What is Straight Line Depreciation?

Straight line depreciation is the simplest and most commonly used depreciation method for allocating a capital asset’s cost, and results in the fewest calculation errors. It determines the loss of an asset’s value over time.

With this method, an asset’s value is uniformly lowered over each period until it reaches its salvage value — the amount an asset is approximated to be worth at the conclusion of its useful life.

An asset’s cost with this basis is depreciated the same amount for each accounting period. This helps to avoid extreme cash-balance and profitability swings on a company’s financial statements. Expensing all at once would have that effect. Key assets can then be depreciated on a business balance sheet or tax income statement.

The name derives from the fact that, if charted, results of the basis appear as a straight line. 

How Does the Process of Straight Line Depreciation Work?

Straight line depreciation involves raising the depreciation expense account on income statements as well as accumulated depreciation on the balance sheet. The method is designed to reflect the underlying asset’s company consumption pattern.

Accumulated depreciation is what is called a contra asset account, meaning that the account balance is really a credit balance. Thus, the basis indirectly lowers a fixed asset’s book value when the two accounts are netted against each other, 

The basis is key because aligning expenses with revenue helps a company more accurately determine its profitability. Specifically, the method results in even, consistent depreciation charges. Thus, it renders financial forecasting and budgeting easier and helps with operating profitability and cash flow analysis.

How Do You Calculate Straight Line Depreciation?

The calculation simply calls for dividing an asset’s cost, minus its salvage value, by the asset’s useful life. 

Annual Depreciation Expense = (Cost of the Asset – Salvage Value) / Useful Life of the Asset

Where:

• Cost of the Asset is the asset’s purchase price
• Salvage Value is the asset’s value at the end of its useful life
• Useful Life of Asset represents the number of periods or years the asset is expected to be used by the company 

Note than an additional calculation method is:

Straight Line Depreciation Rate = Annual Depreciation Expense /  (Cost of the Asset – Salvage Value)

Here are calculation steps:

1. Determine the asset’s cost.
2. To get the total depreciable amount, subtract the asset’s estimated salvage value from the asset’s cost.
3. Determine the asset’s useful life.
4. For the annual depreciation amount, divide the total of step number two by the number arrived at in step number three.

What Kinds of Assets Can Be Used for Straight Line Depreciation 

Straight line depreciation typically covers fixed assets such as real estate, equipment, and machinery, as they are expected to last more than one year. Because these assets are relatively high cost, depreciation aims to spread out their costs over the period they will be in use.

Note these examples of the useful lives of common assets:

• Five years for office equipment such as fax machines and copiers.
• Seven years for fixtures and office furniture.
• Five years for cars and trucks.
• Three years for manufacturing tools, livestock, and tractors.

What is an Example of Straight Line Depreciation?

When it comes to real estate, the basis is the property’s depreciation in equal amounts over its useful life. 

Say a property bought for $180,000 is depreciated employing a tax life of 27.5 years. That would call for dividing the $180,000 by 27.5 to get an annual straight line depreciation of $6,545, the amount that can be deducted.

Note that the assumption is that the property is rented out. The recovery period for residential rental property is set by the IRS at 27.5 years. 

What are the Benefits and Limitations of Straight Line Depreciation?

There are potential benefits and drawbacks with most anything in the financial space, including straight line depreciation.

As for advantages, the method is simple and relatively easy to use compared to other depreciation methods and mitigates the amount of necessary record keeping. Straight line depreciation also applies to a wide variety of fixed assets.

The method also yields fewer errors over the asset’s life. Thus, the same amount is expenses each accounting period.

In terms of limitations, it is straight line depreciation’s simplicity that also can be counted as a demerit. How so? The calculation of useful life is frequently guesswork based. For example, the risk is always present that technological innovation could make the asset obsolete earlier than anticipated.

Also, the accelerated loss of an asset’s short-term value is not factored in. Neither is the probability that the asset will cost more to maintain with age. Among different companies, useful life and salvage value estimates can be inconsistent.

How Does Straight Line Depreciation Compare to Other Depreciation Methods?

Compared with the depreciation method of double-declining balance — an accelerated depreciation approach — straight line depreciation is more user friendly. After all, to calculate the amount of depreciation each accounting period, the straight line basis only uses three variables.

Note that although an asset’s purchase price is known, assumptions must be made regarding salvage value and useful life. Further, straight line depreciation assumes a steady and unchanging decline rate of an asset’s value. 

Such assumptions may not always be applicable, in which case another method may be better. Such methods can include units of production, sum of the year’s digits, declining balance, and modified accelerated cost recovery system.

Whatever depreciation method is used for fixed assets, the same one should generally be used over time. Because of its easy calculation and the fact that it is less prone to error, straight line depreciation is a common default.

Alternative Investments and Portfolio Diversification

Alternatives can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. A more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. That also meant the potentially exceptional gains these investments presented were also limited to these groups.

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In Summary

Straight line depreciation makes it easier to calculate the expense of a company’s fixed asset. It reduces a tangible asset’s value, which reduces tax liabilities. 

The method can also help investors determine a company’s value in addition to future earnings potential. This can help them decide where to take positions.