Straight-line Method of Depreciation
In straight line depreciation method, cost of a fixed asset is reduced uniformly over the useful life of the asset. Since depreciation expense charged to income statement in each period is the same, the carrying amount of the asset on balance sheet declines in a straight line.
Due to its simplicity, straight line method of depreciation is the most commonly used depreciation method. Accounting principles require companies to depreciate its fixed assets using method that best reflects the pattern in which the assets are being used. While the straight-line method is appropriate in many situations, some fixed assets lose more value in initial years. In such situations other depreciation methods are more appropriate.
Depreciation expense under straight line method is calculated by dividing the depreciable amount of the fixed asset by the useful life of the asset.
|Depreciation Expense: Straight-line Method =||Depreciable Amount|
Depreciable amount equals cost minus salvage value. Cost is the amount at which the fixed asset is capitalized. Salvage value (also called residual value or scrap value) is the estimated value of the fixed asset at the end of its useful life.
Since an amount equal to the salvage value can be recovered by selling the asset, only the difference between the cost and the salvage 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.
Normally purchase of fixed assets does not coincide with the start of financial year. In such situations, some companies elect to charge the whole year depreciation to income statement in the year of purchase (and do not charge any depreciation in the year of disposal). Another more appropriate option is to charge proportionate depreciation for partial year.
|Depreciation Expense: Straight-line Method for a Partial Year = DE ×||N|
DE is the depreciation expense for a complete financial year.
N is the number of months during which the fixed asset was available for use.
Depreciation expense under the straight line depreciation method is journalized as follows:
The same journal entry is posted at the end of each year of the useful life because the amount charged to expense is each full year is the same.
On 1 Jan 2011, Company A purchased a vehicle costing $20,000. The company expects the vehicle to be operational for 4 years at the end of which it can be sold for $5,000. Calculate depreciation expense for the year ended 31 Dec 2011, 2012, 2013 and 2014.
Depreciable amount of the vehicle is $15,000 ($20,000 cost minus $5,000 salvage value). Useful life is 4 years.
Depreciation expense for year ended 31 Dec 2011 = $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 year ended 31 Dec 2012, 2013 and 2014.
Example 2: Proportionate Depreciation
Assume the same data as in Example 1 above. Suppose Company A’s year end is 30th June instead of 31st December.
Under this scenario the vehicle is used only for 6 months in the financial year ended 30 June 2011. Proportionate depreciation should be charged which is calculated by multiplying the full year straight line depreciation expense by a fraction representing the part of the accounting year during which the asset was used.
Depreciation expense for year ended 30 June 2011 = [ ($20,000 − $5,000) ÷ 4 ] × 6/12 = $1,875
Full year depreciation shall be charged in financial year ended 30 June 2012, 2013 and 2014. Partial depreciation shall be charged in the year of disposal i.e. financial year ended 30 June 2015.
The following depreciation schedule presents the asset’s income statement and balance sheet presentation in each of the years.
|Year ended 2011-06-30||1,875||18,125|
|Year ended 2012-06-30||3,750||14,375|
|Year ended 2013-06-30||3,750||10,625|
|Year ended 2014-06-30||3,750||6,875|
|Year ended 2015-06-30||1,875||5,000|
Please note that the carrying amount of the asset will never fall below the salvage value because this is the amount which can be recovered even when the asset is no longer being used.
Other important methods of depreciation are the declining balance method, the units of production method and the sum of the years' digits method of depreciation.
EXERCISE: Plot the depreciation schedule above on a graph to see if it forms a straight-line.
Written by Obaidullah Jan, ACA, CFA