Straight-Line Depreciation Method
Investing Lesson 4 - Analyzing an Income Statement
The simplest and most commonly used depreciation method when calculating depreciation expense on the income statement is known as the straight line depreciation method. Although it might seem intimidating, the straight-line depreciation method is the easiest to learn. The calculation is straightforward and it does the job for a majority of businesses as these firms don't need one of the most complex methodologies.
How to Calculate the Straight Line Depreciation Method
To calculate the straight line depreciation method, you need to take the purchase price or acquisition cost of an asset then subtract the salvage value at the time it is either retired, sold, or otherwise disposed of. Then, you divide this figure by the total product years the asset can reasonably be expected to benefit the company (this is called the "useful life" in accounting jargon). In other words, writing it out like a math problem:
- Straight Line Depreciation = (Purchase Price of Asset - Approximate Salvage Value) ÷ Estimated Useful Life of Asset
An Example of a Straight Line Depreciation Calculation
You own a small business and decide you want to buy a new computer server at a cost of $5,000. You estimate that at the end of its useful life, there will be $200 in salvage value for the parts, which you can sell to recoup some of your outlay.
Existing accounting rules allow a maximum useful life of five years for computers. In the past, your business has upgraded its hardware every three years so you believe this to be a more realistic estimate of useful life because you are apt to dispose of the computer at that time. Using this information, you can calculate the straight line depreciation cost as follows:
- Step I: ($5,000 purchase price - $200 approximate salvage value) ÷ 3 years estimated useful life
- Step 2: $4,800 ÷ 3
- Answer: $1,600 annual straight-line depreciation expense
Understanding How Depreciation Charges Fit With the Income Statement, Balance Sheet, and Cash Flow Statement
In the example we just calculated, here is what would actually happen, assuming you bought the computer for cash.
- $5,000 would be moved from the cash and cash equivalents line of the balance sheet to the property, plant, and equipment line of the balance sheet.
- At the same time, the cash flow statement would show a $5,000 outflow for capital expenditures.
- $1,600 would be charged to the income statement each year for three years. This means that even though you parted with $5,000 in year one and $0 each year thereafter, you'd actually show profits reduced by $1,600 in year one, $1,600 in year two, and $1,600 in year three.
- Each of those $1,600 charges would be balanced against a contra-account under property, plant, and equipment on the balance sheet known as accumulated depreciation, which effectively reduces the carrying value of the asset. For example, after the first year, the balance sheet would show a $5,000 computer offset by a $1,600 accumulated depreciation contra-account so the net carrying value would be $3,400.
- At the end of three years, the carrying value would be $200 on the balance sheet, the depreciation expense would be completed under the straight line depreciation method, and management would retire the asset. The sale price would find its way back to cash and cash equivalents, any gain or loss above or below the estimated salvage value would be recorded, and there would no longer be any carrying value under the fixed asset line of the balance sheet.
The Use of the Straight Line Depreciation Method, Or Any Other Depreciation Method, Can Result In Tax Timing Differences In the Reported Financial Statements
One quirk of using the straight-line depreciation method on the reported income statement arises when Congress passes laws that allow for more accelerated depreciation methods on tax returns than management decides to employ on the reported financial statements put together under the GAAP rules.
When this occurs, management is likely going to take advantage of it because it can increase intrinsic value.
Specifically, while the reported earnings figures more accurately represent economic reality due to the smoothed nature of the straight line depreciation method, taking the tax deduction upfront by accelerating depreciation on the tax return can mean more cash saved this year. That is cash that can be put to work for future growth or bigger dividends to owners. (You know the time value of money that, in most cases, a dollar today is more valuable than a dollar in the future.)
However, this results in a problem. The tax records don't match the accounting records. Fortunately, they will balance out in time as the so-called tax timing differences resolve themselves over the useful life of the asset. In the meantime, special adjustments need to be made to the reported financial found in the annual report and 10-K filing.
The specifics of these adjustments aren't important to you right now. The simplified version is that a special deferred tax asset will be put on the balance sheet to serve as a way to adjust for the difference between the income statement and cash flow statement. Over time, that deferred tax asset will be reduced until the reported income under GAAP and the reported income to the IRS align at the end of the straight line depreciation schedule.
The Straight Line Depreciation Calculation Should Make It Clear How Much Leeway Management Has In Managing Reported Earnings In Any Given Period
By now, you may have had a thought: It seems like management has a lot of discretion in determining how high or low reported earnings are in any given period. You're right. Depreciation policies play into that, especially for asset-intensive businesses.
On the other hand, there are generally accepted depreciation estimates for most major asset types that provide some constraint. These are found in publications called Asset Life tables. For example, according to The Clorox Company, one of the world's largest cleaning supply manufacturers, uses the following depreciation schedule in its calculations:
- Land improvements are depreciated over 10 to 30 years
- Buildings are depreciated over 10 to 40 years
- Machinery and equipment are depreciated over 3 to 15 years
- Computer equipment is depreciated over 3 years
- Capitalized software cost is depreciated between 3 to 7 years
- Furniture and fixtures are depreciated between 5 to 10 years
- Transportation equipment is depreciated over 5 to 10 years
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.