Explanation of Straight-Line Depreciation
Companies provide for depreciation to record their assets at their true and current market values. The value of an asset declines rapidly with the passage of time due to use and obsolescence. By providing for depreciation, companies can ward off losses when they sell the asset. There are several ways to provide for depreciation. The straight-line method is the oldest.
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Straight Line Method
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The straight-line method (SLM) depreciates the asset by a constant amount each year until the end of its useful life. When buying the asset, the company decides on its useful life and the value at which the firm is likely to sell it when it stops functioning (scrap value). At the end of every year, the company deducts the same amount from the asset until the end of its productive tenure.
Formula
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The formula for the SLM is the cost of the asset, minus scrap value, divided by the number of productive years. For example, if the company purchased equipment for $6,000 and estimates the scrap value to be $1,000 and the number of useful years to be five, it would calculate depreciation as follows: $6,000 -$1,000)/5 = $1,000. Accountants would depreciate the asset by $1,000 annually for five years.
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Benefits
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The main benefit of using the straight-line method of depreciation is simplicity. You have no complicated calculations to make. You calculate the amount when you buy the asset and subtract the same amount each year. Financial projections and cost comparisons are easy with the straight-line method. Companies usually apply this method to depreciate fixed assets.
Limitation
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Assets are likely to be more useful in their earlier years than later. Depreciating the asset at the same constant sum often does not reflect the true picture. Newer, improved versions of the same equipment may be on the market and there may be no buyers for the company's asset. It is in the company's best interest to provide for more depreciation in the asset's initial years. This way, the company would not suffer a loss when eventually disposing of the asset.
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