The Straight-Line Depreciation Method & Its Effect on Profits
The straight-line depreciation method, by far the most common method used by businesses for their financial accounting, allocates the cost of an asset in equal amounts over the course of that asset's useful life. Because the depreciation expense is equal each year, profits are reduced by a uniform amount each year.
To create a straight-line depreciation schedule for an asset, you need three pieces of information. First is the asset's original cost -- how much it cost not only to buy the asset but also to put it into service, including transportation and setup costs. Second is the useful life of the asset -- how many years you expect to be able to use the asset to generate revenue. Last is the asset's estimated salvage value -- how much you think you could sell it for at the end of that useful life.
Calculating straight-line depreciation starts by subtracting the estimated salvage value from the original cost of the asset. The result is the asset's depreciation base, or how much will be depreciated. Now simply divide the depreciation base by the number of years in the estimated life of the asset. This gives you your annual depreciation expense for the asset. For example, say an asset has an original cost of $10,000, a salvage value of $800 and an estimated useful life of eight years. The depreciation base is $9,200. Dividing that by eight years gives you an annual depreciation expense of $1,150.
Expenses directly reduce your company's profit. With straight-line depreciation, the expense is the same each year, so the reduction in profit is the same each year. In the case of the example, your profit is reduced by $1,150 each year of the asset's life. Note that depreciation is a non-cash expense: You aren't actually "spending" $1,150. Rather, you're recording an expense for a portion of the $10,000 you spent back when you acquired the asset. Depreciation reduces profit but not cash flow.
Alternatives to the straight-line method involve "accelerated" depreciation schedules. These methods depreciate a greater portion of the asset's cost in the earliest years of its useful life and a lesser amount in later years. The result is that profits take the biggest hit early on, and the effect gets smaller over time. The benefit to accelerated depreciation comes at tax time. Lower profits mean lower taxes. Companies generally like to realize tax savings as soon as possible, and accelerated schedules push those savings forward. In fact, it's common -- and perfectly legal -- for companies to use straight-line depreciation for their financial accounting and accelerated depreciation for tax accounting.
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton, et al; 2010
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