What is the Straight Line Depreciation Method?
Straight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life, and the cost of the asset is evenly spread over its useful and functional life. Thus, the depreciation expense in the income statement remains the same for a particular asset over the period. As such, the income statement is expensed evenly, so is the value of the asset on the balance sheet. The carrying amount of the asset on the balance sheet reduces by the same amount.
Colgate’s Straight Line Depreciation Method
source: Colgate SEC Filings
- Colgate follows the straight-line method of depreciation. Its assets include Land, building, machinery, and equipment; all of them are reported at costs.
- The useful life of machinery and equipment ranges from 3 to 15 years
- The useful life of the building is a bit longer than 40 years.
- Also, you should note that depreciation is not reported separately in Colgate. They are included either in Cost of SalesCost Of SalesThe costs directly attributable to the production of the goods that are sold in the firm or organization are referred to as the cost of sales. or Selling, general and admin expenses.
Straight-line depreciation method can be calculated using the following formula:
The straight-line method of calculating straight-line depreciation has the following steps:
- Determine the initial cost of the asset at the time of purchasing.
- Determine the salvage value of the assetSalvage Value Of The AssetSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000., i.e., the value at which the asset can be sold or disposed of after its useful life is over.
- Determine the useful or functional life of the asset
- Calculate the depreciation rate, i.e., 1/useful life
- Multiply the depreciation rate by the cost of the asset minus the salvage cost
The value we get after following the above straight-line method of depreciation steps is the depreciation expense, which is deducted on income statement every year until the useful life of the asset.
Straight Line Depreciation Method Examples
Suppose a business has bought a machine for $ 10,000. They have estimated the useful life of the machine to be 8 years with a salvage value of $ 2,000.
Now, as per the straight line method of depreciation:
- Cost of the asset = $ 10,000
- Salvage Value = $ 2000
- Total Depreciation Cost = Cost of asset – Salvage Value = 10000 – 2000 = $ 8000
- The useful life of the asset = 8 years
Thus, annual depreciation cost = (Cost of asset – Salvage Cost)/Useful Life = 8000/8 = $ 1000
Hence, the Company will depreciate the machine by $1000 every year for 8 years.
- We can also calculate the depreciation rate, given the annual depreciation amount and the total depreciation amount which is annual depreciation amount/total depreciation amount
- Hence, depreciation rate = (annual depreciation amount/total depreciation amount)*100 = (1000/8000)*100 = 12.5%
Depreciation account of the balance sheet will look like below over the 8 years of the machine’s life:
How to adjust the depreciation charges on the Balance sheet, Income statement, and the cash flow statement?
As can be seen from the above table – At the end of 8 years, i.e., after its useful life is over, the machine has depreciated to its salvage value.
Now, we will look into how this expense is charged on the Balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company., income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements., and cash flow statement in detail. Let us take the above example of the machine:
- When the machine is bought for $ 10000, the cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. are reduced by $ 10000 and moved to the Property, plant and equipment line of the balance sheet.
- At the same time, an outflow of $ 10000 is shown in the cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities..
- Now, $ 1000 will be charged to the income statement as a depreciation expense for 8 continuous years. Although, all the amount is paid for the machine at the time of purchase, however, the expense is charged over a period of time.
- Every year $1000 is added to a contra accountContra AccountContra Account is an opposite entry passed to offset its related original account balances in the ledger. It helps a business retrieve the actual capital amount & amount of decrease in the value, hence representing the account’s net balances. of the balance sheet, i.e., Property, plant, and equipment. It is called accumulated depreciation. This is to reduce any carrying valueCarrying ValueCarrying value is the book value of assets in a company's balance sheet, computed as the original cost less accumulated depreciation/impairments. It is calculated for intangible assets as the actual cost less amortization expense/impairments. of the asset. Thus, after 1st year the accumulated depreciationAccumulated DepreciationThe accumulated depreciation of an asset is the amount of cumulative depreciation charged on the asset from its purchase date until the reporting date. It is a contra-account, the difference between the asset's purchase price and its carrying value on the balance sheet. will be $ 1000, after 2nd year it will be $ 2000 and so on…till the end of the 8th year, it will be $ 8000.
- After the useful life of the machine is over, the carrying value of the asset will be only $ 2000. The management will sell the asset, and if it is sold above the salvage value, a profit will be booked in the income statement or else a loss if sold below the salvage value. The amount earned after selling the asset will be shown as the cash inflow in the cash flow statement, and the same will be entered in the cash and cash equivalents line of the balance sheet.
- It is the simplest method of depreciating an asset.
- It is most commonly used and easy to understand method.
- It does not involve complex calculations; hence, chances of errors are less.
- Since the asset is uniformly depreciated, it does not cause the variation in the Profit or loss due to depreciation expenses. In contrast, other depreciation methods can have an impact on Profit and Loss Statement variations.
In the article, we have seen how the straight line depreciation method can be used to depreciate the value of the asset over the useful life of the asset. It is the easiest and simplest method of depreciation where the cost of the asset is depreciated uniformly over its useful life.
Straight Line Depreciation Video
This article has been a guide to the Straight Line Depreciation method and its definition. In this, we discuss the Straight-line method along with practical examples (Colgate) and its impact on the Income Statement, Balance Sheet, and Cash Flows. You may also learn more about basic accounting from the following articles –