Straight line deprecation: it’s one of the most important ways to measure the life of your company’s tangible assets. But if you’re like 60% of small businesses, you may not have confidence in your financing and accounting skills.
Understanding straight line depreciation is necessary to master your wealth management and matters for both your cash flow management and tax preparation.
We’ve created the following guide explaining how to calculate straight-line depreciation for an asset. This new skill will play a major role in your financial planning. Keep reading to find out.
What is Straight Line Depreciation?
Business owners use straight-line depreciation to write off the expense of an asset. This method will gradually reduce the value of a fixed or tangible asset over time. (You would amortize intangible assets).
Straight line depreciation appears on your balance sheet as a fixed cost. It will reduce your net income but will be added back into your operating cash flow because it is not an operating cash expense.
It is the easiest depreciation method because it uses consistent depreciation over time. Other methods of deprecation will adjust expenses based on the assets’ use.
With straight-line depreciation, you’re less likely to make errors with your account because it is easier to calculate. Other methods use more complex formulas, which may cause problems for those who are new to depreciation.
How to Calculate Straight-Line Depreciation
You can calculate straight-line depreciation in just five steps. Let’s use this situation to illustrate how to use the formula.
Mark owns a small shipping company. He recently purchased a truck to deliver packages that cost $40,000. It cost $1,000 to transport the truck to him, and taxes were $4,000, making the total cost $45,000.
Step 1: Calculate the Asset Cost
As explained above, the total cost of Mark’s truck was $45,000. Notice that we included the tax and transportation.
When calculating the cost of an asset, include all related costs. So if you’re calculating the cost of furniture installation for your business, include the material costs and labor.
The final costs of an asset should always include taxes, handling, and delivery. These costs will be used to calculate depreciation costs.
Step 2: Subtract Salvage Value
You’ll calculate the straight-line depreciation of your asset after you subtract its salvage value. Salvage value is what you expect the asset to be worth after it is no longer useful.
Say that Mark expects his truck to last 5 years and have a value of $8,000 after its useful life. He would subtract this value and end up with this number:
$45,000 – $8,000 = $37,000
You cannot always be sure what the exact value of your asset will be. When in doubt, underestimate rather than overestimate the salvage value.
3. Determine the Useful Life
We mentioned above that Mark expects his truck to have a useful life of 5 years. This means that he expects he will be able to use the truck as an asset within his business for those 5 years.
Common assets and their useful lives typically look like this:
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- Tractors, manufacturing tools: 3 years
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- Vehicles including cars and trucks: 5 years
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- Office machines: 5 years
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- Furniture and fixtures: 7 years
IRS Publication 946 gives a complete list of assets and their useful lives, including exceptions and special cases for depreciation.
The easiest way to determine the useful life is to refer to the IRS tables found in Publication 946. For more confirmation, we recommend connecting with an accounting expert.
Step 4: Determine Annual Depreciation Rate
In this step, you’ll divide 1 by the number of years of the asset’s useful life. This will determine the annual deprecation rate.
Take Mark’s truck. With a useful life of 5 years, we would calculate it as follows:
1 / 5 = 0.20
Mark will depreciate his truck at a rate of 20% per year.
When determining straight-line deprecation, remember to always begin with the number of years, not the value of the asset. Always start your calculation with 1.
Step 5: Calculate Depreciation Cost
Now that you have the depreciation rate, you can find the actual depreciation cost. This step involves multiplying the depreciation rate from step 4 by the value of the asset from step 2.
In this case, step 2 found that Mark’s truck had a value of $37,000 after subtracting the salvage value. We would multiply this number by the depreciation rate of 0.2 in a calculation that looks like this:
0.2 ($45,000 – $8,000) = $7,400
Or
20% ($37,000) = $7,400
The annual depreciation expense for Mark’s truck amounts to $7,400.
Bonus: Monthly Depreciation
You don’t have to only use straight-line deprecation on an annual basis. You can also calculate your monthly expense, as you’re more likely to record your expenses monthly during your financial planning.
Find your monthly deprecation rate by dividing the annual rate by 12. For Mark, it would look like this:
$7,400 / 12 = $616.67
Mark’s monthly deprecation expense is about $615.
Try Straight Line Depreciation Yourself
Think you’ve got it? Test your knowledge about straight line deprecation below.
Jennifer recently purchased furniture for her new office, including desks, chairs, and tables. The furniture itself cost $8,000. Taxes were $1,000, and shipping was $2,000. She expects salvage value to be $2,000.
What is the monthly depreciation rate?
Step 1: Calculate the Asset Cost
In this case, the furniture costs $8,000. With taxes and shipping, the total becomes $11,000.
Step 2: Subtract Salvage Value
Jennifer expects salvage value to be $2,000. So we would calculate:
$11,000 – $2,000 = $9,000
Step 3: Determine the Useful Life
As mentioned above, the IRS records the useful life of office furniture at 7 years. Jenner’s furniture would apply to this rule.
Step 4: Determine Annual Depreciation Rate
Remember that you’ll start with the number 1 in this step. Divide 1 by the furniture’s useful life:
1 / 7 = 0.142857
Try to keep at least 4 decimal places to prevent rounding errors.
Step 5: Calculate Depreciation Cost
We’ll take the rate of 0.142857 and multiply it by the value of the furniture after subtracting its salvage value:
(.142857) (9,000) = $1,285.71
The annual depreciation expense is $1,285.71.
Step 6: Calculate Monthly Depreciation
Divide the number from step 5 by 12:
$1,285.71 / 12 = $107.14
Jennifer’s monthly depreciation expense on her furniture is $107.14.
Optimizing Your Business’s Wealth Management
Straight-line depreciation is just one of the tools that you need to know in order to master your business’s wealth management.
And you don’t need to do it alone – the Bogart Wealth Company team is happy to assist you with your company’s financial activities, whether it’s risk management or investment planning.
Contact us to learn more about what we offer and how we can help optimize your business’s weath.
