Finance, Tax & Admin

What is Straight Line Depreciation and Why is it Important?

Business Advice | 11 August 2023 | 9 months ago

There’s always something to pay for as a business owner. Regardless of the industry that a business is in, equipment, machinery and property are all important parts of keeping things running. All of these can be a huge expense, one that’s hard to pay out in one go, especially if it’s going to put a big dent in your finances. This is where straight line depreciation comes in. With straight line depreciation, it’s possible to align the expense of an asset with the revenue of a business over a long period of time.

What is Straight Line Depreciation and Why is it Important?

What is Straight Line Depreciation?

The term ‘depreciation’ is used in accounting to spread the cost of a fixed asset, and it’s often used for property and equipment, covering the period of time that the asset is likely to be used. Depreciation enables a business to align the expense of an asset with the revenue that the asset creates, which helps to determine profitability. There are a range of depreciation methods out there, one of which is straight line depreciation. This is a simple, straightforward and accurate way of working out the value of an asset during the time it will be of use to the business.

Many assets – such as machinery, property and equipment – are all bought with the expectation of them lasting for a long time, usually for a number of years. As these assets tend to cost a lot of money, depreciation is there to ‘smooth out’ the investment over the set period of time that they will be used. This is an effective way of avoiding big changes in cash balances and profitability, which come when an asset is expensed all at once. Instead, the cost is spread out as the asset depreciates in value. Straight line depreciation assumes that the asset will decline in usefulness on a constant and expected basis, hence the straight line on a graph.

 

How is Straight Line Depreciation Calculated?

In order to calculate straight line depreciation, you need to take into account the asset cost and how long the asset will be useful. You also need to consider how much the asset is likely to be worth at the end of its useful life, which is known as its ‘salvage value’. This will help you to determine how much the asset will depreciate in value during your ownership. You also need to consider the asset’s ‘depreciable base’, which is the difference between how much the asset costs and its salvage value. The ‘depreciable base’ can then be divided by the useful lifetime of the asset (in years) to calculate the annual depreciation expense.

 

Why Does Straight Line Depreciation Matter?

Straight line depreciation is important, as it enables you to match the expense of buying an asset with the value that it will have. This will help you to more accurately determine your business’ profitability and revenue. With straight line depreciation, stable depreciation charges are calculated, making it easier for you to budget. Instead of one large cost being taken into account, the useful life and depreciating value are also factored in. Straight line depreciation also makes your financial forecasting more accurate, and a lot easier to calculate. By expensing the cost of an asset over its useful life, its decreasing value is accurately represented as it is used and gradually worn out. This provides a more accurate representation of a business’ financial position.

Straight line depreciation helps you to plan for future asset replacements or upgrades. By knowing when an asset’s value is expected to be fully depreciated, you can anticipate when you will need to find the funds to purchase a replacement, allowing you to maintain your operations. It reduces the risk of an asset needing to be replaced, but a business not having the reserves in place to do so, which can hinder productivity.

 

Is Straight Line Depreciation Accurate?

Though straight line depreciation is somewhat accurate, it does have a handful of limitations, and it might not always be the most accurate way of determining how an asset’s value will decrease. For example, straight line depreciation assumes what an asset’s usage and decline in value will be. It doesn’t take into account that wear and tear could happen sooner than you expect, or the fact that assets often depreciate slower in later years. Straight line depreciation also fails to account for changes in the market value of an asset, and some assets might lose value sooner than others as new technology is released or market demands change.

Another drawback of straight line depreciation is that it doesn’t consider the impact of maintenance and repairs. The useful life of an asset can be significantly extended with maintenance, but a lack of maintenance can shorten it. Straight line depreciation doesn’t take this into account. There’s also no consideration for how much an asset is used when straight line depreciation is being calculated. For example, if an asset is used a lot to begin with and then less as the years go on, straight line depreciation might not align accurately with actual wear and tear.

 

There are a variety of ways to determine depreciation, including the units-of-production method. This takes the useful life of an asset in relation to the output it’s expected to have. Sum-of-the-years’-digits is another option, which leads to lower depreciation charges in successive years. There’s also the declining-balance method, which applies a consistent depreciation rate to create higher depreciation charges in the earlier years of an asset’s useful life.

 

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