Business assets will either appreciate or depreciate. Assets that appreciate, like property values or your brand, typically increase in value over time, meaning you can sell them for more than you paid originally. Depreciating assets, like equipment, technology, and vehicles, often lose value—causing you to sell for less than you paid.
There are multiple ways to track the depreciation of your assets, each offering further insight into the financial standing of your business. This guide will focus on straight-line depreciation to better understand whether this model is right for your accounting purposes.
What Does Straight-Line Depreciation Mean?
Straight-line depreciation is an accounting method that depreciates an asset by the same amount each year of its useful life.
If you assume an item will depreciate by a set amount over 1 year, you can calculate its value 10 or 20 years from now using this model. The name comes from the straight line on the chart that reflects the item’s value over time.
How Do You Calculate Straight-Line Depreciation?
Straight-line depreciation requires you to work backward in your accounting process. Start with the purchase price—or the amount you paid to acquire the asset. This includes its shipping rate, installation fees, and other costs.
Then, calculate the value of the asset at the end of its useful life. For a fleet vehicle, what is its trade-in value? For equipment, what can you get for scrap metal?
Finally, estimate how long an item is expected to last. For example, a well-maintained vehicle could last your company more than a decade. In contrast, an air conditioner might only last 5–10 years in some areas.
Once you have this information, you can fill out the following formula:
Annual Depreciation = (Purchase Price – Salvage Value) / Useful Life
Let’s use a piece of kitchen equipment as an example. If you spend $10,000 on an item and estimate that it can sell for $200 as scrap after 10 years, then your formula would look like this:
- Annual depreciation = ($10,000 – $200) / 10
- Annual depreciation = $980
With this method, annual depreciation is represented as a dollar value, meaning this is the amount you need to subtract from the assets each year. When you’ve owned your piece of equipment for 1 year, its $10,000 value will depreciate to $9,020.
What Are the Pros and Cons of Straight-Line Depreciation?
There are multiple depreciation models that you can use, but the straight-line model is arguably the simplest. It’s mostly based on estimates, and the depreciation amount remains the same each year. If an accountant needs to report the changing values of a company quarterly or annually, then they can quickly track the value of assets based on historical data.
However, the benefit of an easy system can also be a drawback. First, the actual value of an item isn’t solely determined by market value. For example, if 2 companies own the same fleet vehicle and bought it at the same time for the same price, 1 could have a considerably higher value if it was serviced regularly; has new tires, belts, and other parts; and is driven less than the other vehicle. Even factors like the business’s location and whether the vehicle was stored in a garage can impact its actual value.
It’s not always fair to depreciate items at the same amount each year, especially if you’re using industry estimates. You may be undervaluing your company if you care for your assets and they maintain their value—but you might be overvaluing it if your assets are in worse shape than could be expected.
When Should I Use a Depreciation Formula?
The type of depreciation formula you choose will likely be determined by its intended use. If you want to track the value of your assets for internal use, then this straight-line depreciation model may be a strong option. If you’re a sole proprietor or small business owner, there likely won’t be major penalties if these calculations are off.
However, if you need to report the value of your company to shareholders, want to deduct depreciation from your taxes, or plan to take out a loan against the value of your business, then you may need a more accurate calculation for depreciation.
Other depreciation formulas (like the double declining balance depreciation method, units of production depreciation method, and the MACRS depreciation method) can tell people exactly which items you have within your business and what they’re worth.
Learn More About Depreciation
If you want to learn more about depreciation, including different methods of calculating the value of your assets, check out the resources offered by Sunrise. On our blog, we discuss a variety of topics ranging from depreciation tracking to filing your taxes accurately. Use these accessible tools to become more informed about your bookkeeping and run your business better.