When you purchase a capital asset for your business, such as manufacturing equipment, a truck or computer software, you need to think about how you will expense the transaction. Most times, you cannot write off the cost in one go. Straight-line depreciation is a method for spreading the cost over the number of years you will be using the asset, where the depreciation expense is the same each year.
TL;DR (Too Long; Didn't Read)
Straight-line depreciation is a simple accounting method for recording the cost of an asset over its useful life. "Straight line" means you are depreciating the same amount each year.
Straight Line Depreciation Explained
Straight-line depreciation is the easiest way to spread the cost of an asset evenly over the number of years you will be using it. For example, if you buy a printer for $5,000 that you will use for five years, write the cost off as $1,000 for each year of the printer’s life. The straight-line method depreciates the exact same amount across every year of the asset's useful life. Other methods of depreciation might weight the deduction toward the early years of an asset's life, especially where an asset loses value quickly.
Why Businesses Use Straight Line Depreciation
Companies use straight-line depreciation primarily to get tax deductions. Whenever you buy a capital asset for your business, tax laws prevent you from writing off the cost in one go. Rather, you must spread the cost across the period you will be using it. You need to complete tax form 4562 and the guidance in publication 946. One exception is the Section 179 expense method which lets you deduct the full cost of qualified assets in a single year up to $1 million. If the asset does not qualify for Section 179, you will have to use depreciation.
Straight Line Depreciation and Financial Reporting
The second reason to use straight-line depreciation is for financial reporting. If you purchased an asset and did not record depreciation, you would have to charge the asset to expenses as soon as you bought it. Your financial statements potentially would show a large, front-loaded loss in the month you incurred the expense, followed by high profitability in later months as you recognize revenue from the asset with no offsetting expenses. Straight-line depreciation allows you to charge part of the asset's cost to periods in which the asset generates revenue. This gives a better picture of how well the business has performed in an accounting period.
Calculating Straight Line Depreciation in Excel
Straight-line depreciation is very simple to calculate using the following formula: (Cost of asset – salvage value)/useful life, which you can run through Excel. Suppose, for example, you bought a vehicle for $25,000 with a useful life of five years and a salvage value – the amount the vehicle would be worth if you sold it at the end of its useful life – of $5,000. Input the following information:
- Type "original cost" into cell A1 and "$25,000" into cell B1
- Type "salvage value" into cell A2 and "$5,000" into cell B2
- Type "useful life" into cell A3 and "5" into cell B3
Now run the calculation "=(B1-B2)/B3." This gives you a depreciation expense of $4,000 in each of years one through five.