Straight line depreciation explained
Depreciation is the reduction in the value of a fixed asset through the passage of time and use. There are many different depreciation methods and calculations available to the accountant and the type used will depend on the types of fixed asset the business owns and business policy. Out of all the different methods of depreciating fixed assets the straight line depreciation method is the easiest to calculate.
The annual straight line depreciation charge is a simple and straight forward calculation that consists of the Cost of the fixed asset less the residual value, which is then divided by the estimated useful economic life.
It is easy to see that the straight line depreciation method is exceptionally easy and requires a basic numerical understanding only, and a calculator just to check the answer. There is no other depreciation method as basic as the straight line depreciation method although this is not a valid reason for using it.
If you take a step back and think about it, the straight line depreciation method is an easy calculation on paper, but in the real world calculating the straight line depreciation charge can be more problematic and requires more thought.
The first point to consider when calculating the straight line depreciation charge is determining the useful economic life. The useful economic life is the length of time you think the asset will be used in the business before it need replacing, i.e. its life expectancy. Different types of fixed assets will have different life expectancies. For example, a computer will become obsolete in a couple of years therefore it will have a short economic life. On the other hand office furniture will last for a number of years and will have long economic life. So when you buy a fixed asset and start the straight line depreciation calculation you need to ask yourself “How long will this fixed asset last?”
The Lotus Elan sports car. If you are lucky enough to have one of these on your asset register it will need to be written off and depreciated. Is the straight line depreciation method the best in this situation? There is no clear yes or no response here and the answer to this depends on specific circumstances
The answer to the above question will vary from individual to individual, even if each person buys exactly the same type of fixed asset. Some people will run fixed assets in to the ground and keep repairing them as opposed to replacing them. However, other people will replace a fixed asset as soon as it goes wrong and needs a repair job.
Determining the useful economic life is a subjective matter, however providing you come up with a reasonable answer and base your answer on sound arguments, you won’t go too far wrong.
The next stage in calculating the straight line depreciation charge is to determine the residual value of the asset. The residual value is defined to be the value of the asset at the end of its useful economic life. Some fixed assets are easier to value than others. For example suppose the business is going to buy a car and use it for three years. Over the three years of ownership the business expects to put 10,00o miles per annum, which totals 30,000 over the life of the asset. Using motor journals and guides, such as Parkers and Glass’, it is possible to make a reasonable estimate of the value of the car in three years time right now.
Unfortunately, there aren’t the same types of publication for all fixed assets, therefore placing a residual value on a fixed asset in order to calculate the straight line depreciation charge is not so straightforward.
The hardest part of calculating the straight line depreciation charge is determining the useful economic life of the asset and the residual value of the asset. Both the useful economic life and the residual value are very subjective and open to interpretation. There is no right or wrong answer and the decisions made will vary from person to person. Once you have both of these figures sorted out the straight line depreciation calculation is exceptionally straightforward and requires no specialist knowledge, providing you use the straight line depreciation calculation formula that is.
Smart phones, like this Blackberry, are used by many businesses on a day to day basis. These are business assets and should be written off and depreciated to reflect the reduction in value.
When calculating depreciation all businesses should use the method that shows the ‘fairest’ fixed asset position. The definition of ‘fairest’ is very subjective, and in reality businesses can use whatever depreciation method they want, and many will opt to choose the straight line depreciation method. In light of the subjectivity all sets of financial statements have an “accounting policies” section in the notes, which sets down how the business deals with specific things. Every set of accounts must have the depreciation policy in the notes to the accounts so the reader can determine exactly how the fixed assets have been depreciated.
The straight line depreciation charge is not a tax allowable expense. When calculating the business tax liability the straight line depreciation charge should be added back to the profit when calculating the profit chargeable to tax. This does not mean businesses miss out on the tax relief though since the straight line depreciation charge is replaced with capital allowances.