The Straight Line Method (SLM) is the simplest and one of the most commonly used methods of calculating depreciation. Under this method, an equal amount of depreciation is charged every year throughout the estimated useful life of a fixed asset.
The basic principle of the Straight Line Method is that the depreciable cost of an asset is allocated equally over its useful life. Therefore, the depreciation expense remains the same in each accounting year until the book value of the asset is reduced to its estimated residual or salvage value.
This method is based mainly on the passage of time. It assumes an equal allocation of the asset’s depreciable cost over the years of its expected useful life.
Calculation of Depreciation under Straight Line Method
Under the Straight Line Method, annual depreciation is calculated by deducting the expected residual or salvage value from the original cost of the fixed asset. The resulting amount is then divided by the estimated useful life of the asset in years.
The formula is:
Annual Depreciation Expense = (Cost of Fixed Asset − Residual Value) ÷ Useful Life of Asset in Years
It may also be expressed as:
DE = (Cost − Salvage Value) ÷ Useful Life
The difference between the original cost and residual value represents the depreciable amount or depreciable cost of the asset. This amount is allocated equally over the estimated useful life of the asset.
Salvage or Residual Value
The salvage value or residual value is the expected value of an asset at the end of its useful life.
The salvage value may be zero. In certain cases, the costs required to retire an asset may result in a negative economic amount. However, for depreciation purposes, the salvage value is generally not calculated below zero.
Under the Straight Line Method, depreciation is charged until the book value of the asset becomes equal to its salvage or residual value.
Example of Straight Line Method
Suppose a vehicle is purchased for $17,000. The expected useful life of the vehicle is 5 years, and its estimated salvage value is $2,000.
The depreciable amount of the vehicle is:
$17,000 − $2,000 = $15,000
Annual depreciation will be:
$15,000 ÷ 5 = $3,000 per year
Therefore, the company will charge $3,000 as depreciation expense every year for five years.
| Year | Depreciation Expense | Accumulated Depreciation | Book Value at Year-End |
|---|---|---|---|
| Original Cost | — | — | $17,000 |
| 1 | $3,000 | $3,000 | $14,000 |
| 2 | $3,000 | $6,000 | $11,000 |
| 3 | $3,000 | $9,000 | $8,000 |
| 4 | $3,000 | $12,000 | $5,000 |
| 5 | $3,000 | $15,000 | $2,000 |
The example shows that the depreciation expense remains constant at $3,000 every year. However, accumulated depreciation increases each year and the book value of the vehicle gradually decreases.
At the end of the fifth year, the book value of the vehicle becomes equal to its salvage value of $2,000.
Book Value under Straight Line Method
The book value of an asset represents its original cost less accumulated depreciation.
The formula is:
Book Value = Original Cost − Accumulated Depreciation
For example, after the first year, the accumulated depreciation on the vehicle is $3,000. Therefore:
Book Value = $17,000 − $3,000 = $14,000
After the second year, accumulated depreciation becomes $6,000. Therefore:
Book Value = $17,000 − $6,000 = $11,000
The book value at the end of one accounting year becomes the book value at the beginning of the next accounting year.
Depreciation continues until the book value of the asset becomes equal to its scrap or residual value.
Effect of Straight Line Depreciation on Financial Statements
Under the Straight Line Method, the same depreciation expense is charged to the Income Statement every year during the useful life of the asset.
Since depreciation is an expense, it reduces the accounting profit of the business. The equal depreciation charge results in an equal depreciation expense in each accounting period.
Accumulated depreciation increases every year by the annual depreciation amount. The increase in accumulated depreciation gradually reduces the carrying or net book value of the fixed asset in the Balance Sheet.
Thus, while annual depreciation expense remains constant, accumulated depreciation continuously increases and the book value of the asset continuously decreases.
Sale of an Asset above Net Book Value
If an asset is sold for an amount greater than its depreciated value or net book value, the excess may be considered a gain.
The amount above the depreciated value may be subject to depreciation recapture. Such gain above the depreciated value may be recognised as ordinary income for taxation purposes.
For example, if the net book value of an asset is $8,000 and it is sold for an amount exceeding $8,000, the excess over the depreciated value represents a gain.
Sale of an Asset below Book Value
If the selling price of an asset is lower than its book value, the difference represents a loss.
The resulting capital loss may be tax-deductible according to the applicable tax treatment.
Thus, the relationship between the sale price and the book value of the asset determines whether a gain or loss arises on disposal.
Sale Price above Original Book Value
If an asset is sold for an amount greater than its original book value or original cost, the gain above the original book value is recognised as a capital gain.
Therefore, the treatment of gain may depend on whether the sale price exceeds the depreciated value or exceeds the original cost of the asset.
Difference between Accounting and Tax Depreciation Rates
A company may choose to depreciate an asset at a rate different from the depreciation rate used by the taxation authority.
When the depreciation amount recognised by the company differs from the amount recognised for tax purposes, a timing difference arises in the Income Statement.
The timing difference occurs because the taxation authority and the company may have different views of the amount of profit at a particular point in time.
Main Characteristics of Straight Line Method
The Straight Line Method allocates the depreciable cost of an asset equally over its estimated useful life. The annual depreciation expense remains constant throughout the depreciation period.
The method is based mainly on the passage of time and is simple to calculate and apply. Accumulated depreciation increases by an equal amount every year, while the book value of the asset gradually decreases.
The asset is depreciated only until its book value becomes equal to its estimated residual or salvage value.
Exam Focus
The Straight Line Method is the simplest and one of the most commonly used depreciation methods. Under this method, an equal amount of depreciation is charged every year over the useful life of the asset.
The formula is:
Annual Depreciation = (Cost of Fixed Asset − Residual Value) ÷ Useful Life
The book value of an asset is equal to Original Cost minus Accumulated Depreciation.
Under the Straight Line Method, annual depreciation remains constant, accumulated depreciation increases every year, and the book value of the asset decreases until it reaches the residual or salvage value.
A difference between the depreciation rate used by the company and the rate used by the taxation authority may create a timing difference in reported profit.