One of the popular ways to calculate depreciation is the straight line method. This story explains what it is and how you can use it.
Our business assets lose their value as they grow old and hence, we need to account for their loss of value. This is where the depreciation comes in. The two most common methods of calculating it are the straight line method and reducing balance method.
You know that an asset loses its value over its productive life. The loss of value is attributable to a variety of factors such as wear and tear and obsolescence of technology.
Hence, by the time the assets run out of their productive life, they will no longer command the price they did at the time of purchase, and you'll be selling them away for significantly lower prices.
Now according to the accounting principles, the value of an asset on the balance sheet should be equal to the value which it currently commands, should it be sold. So if you purchased an asset 5 years ago for $50,000, it is unlikely that it still commands the same value today.
So, if the balance sheet says that the value of the asset is $50,000 today, it would be incorrect.
Hence, calculating depreciation is important because it helps the business ascertain the correct market value of its assets.
Using the Straight Line Method
In this method, the user of the asset decides how many years he intends on using the asset. He may ascertain the usable life of the asset based on his experience with the particular asset, or may decide the depreciation rate based on what the law decrees it to be.
For the sake of this example, we will assume that you have an asset worth $20,000, and you estimate that it will be useful to you for about 10 years. Then, you'll be writing off (depreciating) $20,000/10, $2,000 each year towards depreciation.
The whole point of it is to reduce the same amount each year. Hence, depreciation is calculated as value at the time of purchase/number of years of usable life.
On the other hand, if the laws in your country state that an asset has to be depreciated at a certain rate by the straight line method, then they will prescribe the rate of depreciation and you will have to depreciate it accordingly. In this case, the number of years of usable life become a lot more dependent on the straight line depreciation rate.
The calculated rate is the percentage of the purchase value which will be deducted every year. So, if the rate is 10%, then the asset will last for 10 years. If the rate is 20%, it will last for 5 years, and so on.
It is always in your best interests to keep a value table for all your assets so that you have a complete record of how much depreciation you're charging each year and how much of the asset value is still remaining. Here's a sample, with the rate assumed to be 25% each year.
Year - 2005 Asset - $10,000 Rate - 25% Amount - $2,500 Value Carried Forward - $7500
Year -2006 Asset - $7500 Rate - 25% Amount - $2,500 Value Carried Forward - $5,000
Year - 2007 Asset - $5,000 Rate - 25% Amount - $2,500 Value Carried Forward - $2,500
Year - 2008 Asset - $2,500 Rate - 25% Amount - $2,500 Value Carried Forward - $0