Straight line method / SL
Straight line method (SL) is the the simplest of the commonly used depreciation schedules. Like all depreciation schedules, it describes the percentage of an asset's depreciable cost that can be claimed as depreciation expense, for each year of the asset's depreciable life (these terms are defined more fully below).
The straight line method spreads depreciation expenses evenly across an asset’s depreciable life: A $100 asset fully depreciated over 5 years (and having no residual value) would allow the owner to claim $20 depreciation expense each year for five years. Other depreciation schedules call for different percentages in each year, usually "accelerating" depreciation by charging relatively more in early years, and relatively less in later years.
A depreciation schedule is one factor in determining the depreciation expense a company can charge against income for an asset. The other important factors are the asset's initial cost, its depreciable cost, its depreciable Life, and its residual value. (These terms are defined and illustrated below).
Depreciation expense is an accounting and financial reporting practice, used primarily by businesses that pay tax on income. On the income statement, depreciation expense appears as a charge against income, that is, it is subtracted from sales revenues to produce a lower reported income (lower profit, lower earnings).
Depreciation provides a way to account for the purchase of long-lasting assets over a period of years. The idea is that assets have a useful life (depreciable life), over which they are used up or worn out, and that the owner receives the tax benefits of paying for the asset over those years instead of all at once.
Straight line depreciation and other schedules are more fully explained and better understood in the context of several depreciation-related terms, as shown in the sections below.
Depreciation Lowers Reported Income
What Can Be Depreciated?
Cash Flow vs. Depreciation Expense
Depreciable Life, Depreciable Cost, and Residual Value
Depreciation Schedules
• Straight Line Depreciation (SL)
• Modified Accelerated Cost Recovery System (MACRS)
• Double Declining Balance (DDB)
• Sum of the Years Digits (SOYD)
• Depreciation Schedules Not Based on Time
• Composite Depreciation
Depreciation Expense: Spreadsheet Implementation
Depreciation Lowers Reported Income
Each year in the life of a depreciable asset, some of its cost is charged against income on the income statement. Just how much is charged each year is determined by the depreciation schedule (see Depreciation Schedules, below).
In the example income statement below, Grande Corporation pays an income tax of 958 on an income (before extraordinary items) of 2,737. Contributing to expenses, however, are three depreciation items totaling 659. Had depreciation been omitted from this statement, Grande Corporation would have had a pre-tax operating income of 3,396 and an income tax of 1,188.
Grande Corporation Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126 |
The tax savings
from depreciation
is thus 230, i.e.,
1,188 –958 = 230.
This tax savings
can also be
estimated directly
as the product of
depreciation
expense and the
tax rate. With a tax
rate on income of
35%, for example,
0.35*659 = 230.
Notice also that
depreciation
expense can
appear in any of
the main expense
categories,
depending on how
the asset in
question is used.
Here depreciation
expense appears
under Cost of
goods sold, as
Manufacturing
overhead
(depreciation of
manufacturing
equipment), under
Selling expenses
(depreciation of
store equipment),
and under General
and administrative
expenses
(depreciation of
computers).
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What Can Be Depreciated?
Generally, depreciation can be claimed for assets that (a) have a useful life of one year or more, (b) are used in a trade or business, and (c) which are used up, wear out, decay, become obsolete, or otherwise lose value over their useful life. Assets that meet these criteria may include factory machines, vehicles, computer systems, office furniture, aircraft, and buildings. Land, however, is an example of an asset that does not meet the third criterion (losing value), and therefore cannot be depreciated in the same way.
Tax laws sometimes give the company's accountants and financial officers a limited choice in deciding whether or not to classify some acquisitions as assets (and therefore eligible for claiming depreciation expense), although the freedom of choice has boundaries. In 2005, for example, several senior executives of Worldcom in the United States were convicted of fraudulent reporting for having overstepped the boundaries, for classifying services paid for by the company as assets rather than as expenses, as they should have been.
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Cash Flow vs. Depreciation Expense
Depreciation expense is an accounting convention, not real cash flow. When a company buys an asset outright with cash, all the cash flows at once in the purchase transaction (this shows up on the company's cash flow statement under "Uses of Cash"). On the income statement, however, the expense is spread across the years of the asset's depreciable life. Depreciation expense thus lowers reported income across several years or more.
Although depreciation expense is not real cash flow itself, it does bring a cash flow consequence each year of the depreciable life. Because depreciation expense lowers reported income, it brings a tax savings that is a real cash flow.
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Depreciable Life, Depreciable Cost, and Residual Value
The depreciation expense claimed for an asset each year normally depends on four factors:
• The asset's depreciable life
• The asset's initial cost
• The asset's residual value
• The depreciation schedule used for the asset
Depreciable Life is the time period over which an asset can lawfully be depreciated. For some assets, management can simply choose a number of years for the depreciable life, based on the the asset's expected useful life. For some kinds of assets, however, the depreciable life is prescribed by the country's tax authorities. In the US, for instance, computing hardware has a prescribed depreciable life of 5 years, and depreciation must follow the MACRS (Modified Accelerated Cost Recovery System) depreciation schedule.
An asset's depreciable life can be different from its economic life. The term economic life refers to actual period of usefulness of an asset, the period beyond which it is cheaper to replace or scrap an asset than to continue maintaining it. Economic life and depreciable life are both central concepts in the practice of asset life cycle management.
An asset is originally valued on the balance sheet at its actual original cost (this is the historical cost convention in accounting). For depreciation purposes, the original cost may include two components:
Original Cost of Asset = Depreciable Cost + Residual Value
Only the depreciable cost component will be claimed as depreciation expense across the years of depreciable life. The asset's residual value (sometimes called salvage value) remains at the end of depreciable life. Residual value is the estimated net value of the asset that would or could be received if the asset were retired or scrapped.
The figure at left shows how an asset originally costing $100 decreases in book value to its residual value over its depreciable life, as depreciation expense is charged each year (the example shows straight line depreciation across a 5 year life).
Most depreciation schedules are applied to the depreciable cost rather than total cost, but the double declining balance method (DDB) is an exception, as is MACRS, a special case of DDB (see Depreciation Schedules, below, for more on these methods). For DDB and MACRS, depreciation percentages are applied against total original cost.
When using any schedule besides DDB and MACRS, residual value plays an important role in determining depreciation expenses, tax savings from depreciation and, possibly, the value of a cash inflow at the end of depreciation. Residual (or salvage) value of an asset has two important tax considerations:
- An asset may NOT normally be depreciated below its estimated residual (salvage) value.
- If, at the end of depreciable life, the realized salvage value of an asset differs from the book value, a tax adjustment will usually be required.
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Depreciation Schedules
The length of an asset's depreciable life and the amount of depreciation a company can claim for it each year, are given by depreciation schedules. Tax laws in each country specify which depreciation schedules can be used for various classes of assets, although in some cases the company has a limited range of schedule choices.
Straight line depreciation (SL): The simplest schedule, so-called "straight line" depreciation spreads depreciation expenses evenly across an asset’s depreciable life: A $100 asset fully depreciated over 5 years (and having no residual value) would allow the owner to claim $20 depreciation expense each year for five years. Other depreciation schedules call for different percentages in each year, usually "accelerating" depreciation by charging relatively more in early years, and relatively less in later years.
MACRS: Many US companies use the 1986 modification of the 1981 Accelerated Cost Recovery System (ACRS) for several classes of assets, known as MACRS. MACRS is thus only for US use. MACRS specifies different schedules for calculating depreciation expense for several kinds of assets: Computing equipment falls into the "5-year class" of property, along with most other office equipment and automobiles. MACRS thus prescribes a 60 month depreciable life for computers, spread across 6 fiscal years (the 60 month period is usually started at the midpoint of year 1). There are several variations and options on MACRS schedules but the primary usage is to apply the double declining balance (DDB) method (see below), using a mid year-1 start. Residual value (salvage value) is ignored. MACRS (along with DDB and SOYD methods, below), is a form of accelerated depreciation, in which relatively more depreciation expense is claimed early in the depreciable life, and relative less is claimed later in the life.
MACRS rules in fact provide two possible depreciation scheedules for different asset classes: a General Depreciation Schedule (GDS) which is most frequently used, and an Alternative Depreciation Schedule (ADS) which may be used in some cases. A few of the GDS and ADS schedules Include:
Office Furniture: GDS 7 Years, ADS 10 Years
Computers: GDS 5 Years, ADS 6 Years
Construction Assets: GDS 5 Years, ADS 6 Years
Railroad cars & Locomotives: GDS 7 Years, ADS 15 Years
The full set of MACRS schedules and rules for various asset classes are given in US Government IRS Publication 946, "How to Depreciate Property."
Double declining balance method (DDB): This is a form of accelerated depreciation that prescribes twice an annual rate of the straight line method. Under the DDB method, twice the straight line rate is applied each year to the remaining undepreciated value of the asset.
Sum -of-the -year’s-digits (SOYD): An accelerated method of depreciation based on an inverted scale of total digits for the years of depreciable life. For five years of life, for example, the digits 1,2,3,4 and 5 are added to produce 15. The first year’s rate becomes 5/15 of the depreciable cost (33.3%), the second year’s rate is 4/15 of depreciable cost (26.7%), the third year’s rate 3/15, and so on.
The table below compares depreciation percentages applied each year against the depreciable cost of an asset having a 5-year depreciable life. (It shows % depreciated per year). The same figures shown graphically below the table.
| Schedule | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 |
|---|---|---|---|---|---|---|
| Straight Line | 20.00 | 20.00 | 20.00 | 20.00 | 20.00 | — |
| MACRS | 20.00 | 32.00 | 19.20 | 11.52 | 11.52 | 5.76 |
| Dbl Decl Bal | 40.00 | 24.00 | 14.40 | 8.64 | 5.18 | — |
| Sum of Yrs Digits | 33.33 | 26.67 | 20.00 | 13.33 | 6.67 | — |
Note that MACRS here refers to a 5-year depreciable life, but which is spread across 6 fiscal years, beginning at the midpoint of year 1.
Non Time-Based Schedules: All of the schedules above are time based schedules because they treat depreciable life as a fixed period of time, charging a given percentage of depreciable cost each year as depreciation expense. Note, however, that sometimes, so called Usage-Based Depreciation is permitted. A vehicle under this plan, for instance, might have its depreciable life defined not in years, but in terms of total miles or kilometers driving expected during its life. The depreciation expense each year would reflect the distance traveled that year as a percentage of the lifetime total. Similarly, other kinds of assets might have depreciable life defined as quantity that will be used up, in which case depreciation percentage each year is based on the quantity used up.
Composite Depreciation: Composite depreciation is a method of depreciation in which a group of related assets is depreciated as a whole rather than individually. This can reduce unnecessary record keeping and reporting and might be used, for example, in depreciating a company’s office furniture, or office equipment. See the encyclopedia entry composite depreciation for an explanation and example.
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Depreciation Expense: Spreadsheet Implementation
The depreciation expense for one asset, each year, is found simply by multiplying its depreciable cost by a given percentage for that year, Calculating total depreciation expenses can be challenging, however, when the total involves multiple assets and multiple schedules across several years or more.
Consider, for instance building a spreadsheet summary of total depreciation expenses for each of five years, with the following assets and schedules involved:
• Asset A, 4 year life, SL schedule, acquired Year 1.
• Asset B, 5 year life, MACRS schedule, acquired Year 2.
• Asset C, 8 year life, DDB schedule, acquired Year 3.
• Asset D,10 year life, SL schedule, acquired Year 4.
Calculating total depreciation expense becomes more complicated with each passing year:
Year 1 Total depreciation expense:
= (Asset A deprec. cost ) * ( SL % for Year 1 of 4 )
Year 2 Total depreciation expense:
= (Asset A deprec. cost ) * ( SL % for Year 2 of 4 ) +
(Asset B deprec. cost ) * (MACRS % for Year 1 of 6 )
By Year 4, Total depreciation expense:
= ( Asset A deprec. cost ) * ( SL % for Year 4 of 4 ) +
( Asset B deprec. cost ) * ( MACRS % for Year 3 of 6 ) +
( Asset C deprec. cost ) * ( DDB % for Year 2 of 8 ) +
( Asset D deprec. cost ) * ( SL % for Year 1 of 10 )
The principles involved in these calculations are simple but the bookkeeping task for the spreadsheet analyst becomes tedious and cumbersome, especially as the number of years considered increases. (You can see and try out working examples of depreciation calculations across multple years, in either Fianancial Metrics Pro or Financial Modeling Pro.)
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