Depreciation: The Straight Line Method
Peter Marshall Bsc (Econ) BA MBIM is a Fellow of the Society of Business Teachers, and an experienced educator in business subjects. He is also a prolific author and his books have been translated and sold worldwide. He lives in London, UK.
When assets drop in value
So far we have recorded figures, analysed them, summed and balanced them, and learned the standard ways of doing so. Now, with depreciation, we will also need to make calculations involving percentages.
Depreciation is the drop in value of an asset due to age, wear and tear. This drop in value is a drain on the firm’s resources, and so we must put it in the accounts as an expense. We will need to write down the value of the asset in the books, to reflect its value more realistically. A company car, for example, loses value over time. So do plant, equipment and other assets. All have to be written down each year.
Methods of calculating depreciation
- straight line method
- diminishing (or reducing) balance method
- sum of the digits method
- machine hours method
- revaluation method
- depletion method
- sinking fund method
- sinking fund with endowment method.
Even this list is not exhaustive. But the first two are the most common.
The straight line method
This involves deducting a fixed percentage of the asset’s initial book value, minus the estimated residual value, each year. The estimated residual value means the value at the end of its useful life within the business (which may be scrap value). The percentage deducted each year is usually 20% or 33⅓% and reflects the estimated annual fall in the asset’s value. Suppose the firm buys a motor van for £12,100; it expects it to get very heavy use during the first three years, after which it would only be worth £100 for scrap. Each year we would write it down by one third of its initial value minus the estimated residual value, i.e. £4,000 per year. On the other hand, suppose we buy a company car for £12,300; we expect it to get only average use and to be regularly serviced. We expect to sell it after five years for £4,800. In that case we would write down the difference of £7,500 by one fifth (20%) each year, i.e. £1,500 per year.
This method is useful where value falls more or less uniformly over the years of the asset’s lifetime.
2. Suppose a machine cost £100,000 and it is estimated that at the end of 5 years it will be sold for £3,125. Suppose also that the greatest usage of the machine will be in the early years as will also the greatest costs, for since it is tailor-made for the firm’s requirements its resale value is drastically reduced the moment it is installed. The appropriate rate of depreciation on the diminishing balance method will be between 2 and 3 times that for the straight line method, so an acceptable rate will be 50%. (See Figure 72.)