Depreciation on a Straight-Line Basis to Residual Value

Business equipment and machinery loses value over time due to depreciation, which the business reports as a regular expense.

In business accounting, depreciation is a means of expensing the value of a major asset purchase over time. There are various ways to account for depreciation, but among the most popular is straight-line depreciation, owing in part to its simplicity. Distinguishing between straight-line depreciation and residual value helps clear up confusion when reporting this significant business expense.

Purposes

In accounting, depreciation serves two purposes. First and probably foremost, depreciation corrects the value of assets to account for the fact that they can no longer be sold at their original purchase prices. This is a kind of non-monetary expense that results from the asset's age. Second, depreciation allows businesses to claim a tax deduction every year on the money they spent purchasing assets, which generally are not deducted as long as the asset has market value.

Residual Value

To calculate depreciation, businesses need information about the asset's purchase price, residual value and useful life. The residual value is sometimes called salvage value and represents the amount of money the asset is expected to be worth at the end of its useful life. Most tangible assets have a residual value because the materials used to produce them are worth money even if the asset can no longer be used for its intended purpose. Residual value is estimated by the company's management and is based on market prices for salvaging similar assets.

Useful Life

The useful life of an asset is the amount of time the business expects it to be functional for its intended purpose. Some assets, such as land, have an indefinite useful life and cannot be depreciated. For accounting purposes, the business's management usually determines useful life based on their expectations and equipment schedule. Some companies plan to use assets as long as physically possible, while others plan to replace them every few years as technology improves.

Using the Straight-Line Basis

In the straight-line basis, the total expected depreciation is determined by subtracting the asset's residual value from its purchase price. This amount is the total value the business expects to lose to wear and tear during the asset's useful life. Total expected depreciation is divided by the asset's useful life -- expressed in years -- to determine the annual depreciation expense. This method is called the straight-line basis because the depreciation expense is the same for each year, as if the asset's value is declining along a straight line drawn between its purchase price and its residual value.

References

• AccountingCoach; Depreciation; Harold Averkamp
• "Mastering Depreciation"; Section 2 -- Depreciation Under GAAP (for Book Purposes); Garo Kalfayan; 2007
• Business Accounting Guides; Straight-Line Depreciation: Steady as She Goes; 2011
• Moneyterms.co.uk; Residual Value; Graeme Pieterz
• TransLegal; Useful Life; Jonathan Bryce

Resources

• Cars.com: Residual Values
• TurboTax: Real Estate Tax and Rental Property
• Internal Revenue Service: How to Depreciate Property