Depreciation is how you record the decrease in value of a tangible asset over its useful life. A tangible asset refers to physical property that holds economic value, which can be used to benefit your business. There are multiple options for depreciation methods, including straight-line and accelerated methods. As a small business owner, it's important to know which method makes the most sense for your business.
What Is Straight Line Depreciation?
Straight-line depreciation deducts the same amount of depreciation each year over the entire useful life of the asset. It gets its name from the theoretical graph of the asset's value over time; it has a constant slope. As you take depreciation on the asset, there is a straight line decreasing over the asset's useful life to its ending value, also referred to as its salvage value.
How to Calculate Straight Line Depreciation
As the name implies, straight-line depreciation is straightforward to calculate. You need to know the cost basis of your asset, its estimated useful life, and its salvage value. The calculation for straight-line depreciation is:
(Cost Basis - Salvage Value) / Useful Life = Annual Depreciation Expense
The cost basis includes the price you paid for the asset itself, but it also includes extra costs you paid such as sales tax, shipping and handling charges, and installation costs. The salvage value is what you expect the asset to be worth at the end of its useful life.
If you're planning to take a depreciation deduction for an asset on your tax return, you need to use the estimated useful life set forth by the Internal Revenue Service (IRS), also referred to as the IRS recovery period. The most common are:
- Automobiles, taxis, buses, and trucks: 5 years
- Office machinery (calculators, copiers, computers, etc.): 5 years
- Office furniture and fixtures (desks, files, cabinets, etc.): 7 years
- Vessels, barges, and other boats: 10 years
- Improvements made directly to land (fences, asphalt, etc.): 15 years
For example, assume you just purchased 15 new office desks for your employees. You paid $4,500, including tax and delivery. Desks fall into the seven-year IRS recovery period. You expect to resell each desk for $20, or $300 total, at the end of seven years. To calculate the straight-line depreciation, you subtract $300 from $4,500 and divide by 7. The annual straight-line depreciation is, therefore, $600. Each year, for seven years, you will record $600 of depreciation.
Straight Line Depreciation vs. Accelerated Depreciation
As mentioned earlier, straight line is one of a few methods to calculate depreciation. Other methods fall under what is referred to as accelerated depreciation methods. Some accelerated depreciation methods include:
- Modified Accelerated Cost Recovery System (MACRS)
- Double Declining Balance (DDB)
- Sum of the Years' Digits (SYD)
Accelerated depreciation methods apply a higher amount of depreciation at the beginning of an asset's useful life and a lower amount of depreciation toward the end. As such, it "accelerates" the depreciation taken in earlier years. Your write-offs will be higher up front if you use an accelerated depreciation method.
Straight-line depreciation is easier to calculate, so it simplifies your accounting process. Larger corporations that report earnings to interested stakeholders may prefer straight line depreciation because it does not lower net income in earlier years.
Proponents of accelerated depreciation methods argue that it more accurately reflects the use, and thus wear and tear, on assets. Businesses generally use tangible assets, such as equipment and machinery, more heavily in the earlier years. Later on, they use the assets less frequently as they are phased out and newer assets replace them. For tax purposes, the accelerated method allows for higher deductions in earlier years.