How to Do Straight-Line Depreciation Step by Step

Depreciation helps businesses account for the loss of asset value over time. The straight-line method is one of the simplest ways to do this, spreading the cost evenly across an asset’s useful life. This approach simplifies financial planning and ensures expenses align with revenue.

Understanding how to apply straight-line depreciation correctly is essential for accurate bookkeeping and tax reporting. Below is a step-by-step guide on calculating, recording, and reflecting depreciation using this method.

Calculating the Depreciable Amount

To determine how much of an asset’s cost can be depreciated, businesses must identify its total purchase price and any portion that will retain value. The purchase price includes not just the base cost but also expenses like shipping, installation, and modifications needed to make the asset operational. These additional costs are capitalized, meaning they are added to the asset’s value rather than expensed immediately.

Some assets retain value even after years of use. This is known as salvage value, or residual value, representing the estimated amount the asset could be sold for at the end of its useful life. For example, if a company buys a delivery truck for $50,000 and expects to sell it for $5,000 after ten years, the depreciable amount is $45,000.

Estimating an asset’s useful life is another key factor. This is the period during which the asset contributes to business operations before becoming obsolete or too costly to maintain. The IRS provides guidelines for different asset categories under the Modified Accelerated Cost Recovery System (MACRS), but businesses may also rely on manufacturer recommendations or industry standards.

Yearly Depreciation Formula

The straight-line depreciation method spreads an asset’s cost evenly over its useful life. The formula is:

(Asset Cost – Salvage Value) ÷ Useful Life = Annual Depreciation Expense

For example, if a business purchases office furniture for $12,000, expecting it to last eight years with no resale value, the yearly depreciation expense would be:

($12,000 – $0) ÷ 8 = $1,500 per year

This method provides a consistent expense amount each year, making budgeting easier. Unlike accelerated depreciation methods, which allocate higher expenses in the early years, straight-line depreciation evenly distributes the cost. This is particularly useful for assets that wear out gradually rather than losing value sharply in the beginning.

For tax purposes, businesses must ensure their depreciation calculations align with IRS rules. While straight-line depreciation is commonly used for financial reporting, tax depreciation often follows MACRS. However, certain assets, such as residential rental property, must use straight-line depreciation over 27.5 years, while commercial real estate is depreciated over 39 years. Understanding these distinctions helps businesses comply with IRS guidelines and avoid tax filing errors.

Recording the Depreciation

Once the annual depreciation expense is determined, it must be recorded in the company’s accounting system. This involves making a journal entry to reflect the reduction in asset value and the corresponding expense. The standard entry debits Depreciation Expense, which appears on the income statement, and credits Accumulated Depreciation, a contra asset account on the balance sheet that offsets the asset’s original cost.

For example, if a company records $3,000 in yearly depreciation for machinery, the journal entry would be:

Debit: Depreciation Expense – $3,000
Credit: Accumulated Depreciation – $3,000

This ensures financial records accurately track the asset’s declining value while maintaining the historical cost principle, which requires assets to be reported at their original purchase price. The accumulated depreciation account grows each year by the same amount, reducing the asset’s book value without altering the initial recorded cost.

Depreciation entries should be recorded consistently at the end of each accounting period—whether monthly, quarterly, or annually—depending on the company’s reporting structure. Many businesses automate this process using accounting software like QuickBooks, Xero, or SAP, which can schedule recurring depreciation entries to ensure accuracy and compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). These systems also help track asset disposals, retirements, or impairments, which require adjustments beyond standard depreciation entries.

Reflecting Depreciation in Financial Statements

Depreciation affects a company’s financial statements by altering reported earnings, asset values, and tax liabilities. On the income statement, it appears as an operating expense, reducing taxable income and affecting net profit. This is particularly significant for capital-intensive industries like manufacturing or transportation, where large asset purchases would otherwise create substantial income fluctuations if expensed all at once. By spreading costs over multiple years, businesses can present more stable earnings trends, which investors and analysts often prefer.

The balance sheet reflects depreciation through the net book value of assets, calculated as the original cost minus accumulated depreciation. For example, if a company owns production equipment initially valued at $500,000 and has recorded $200,000 in accumulated depreciation, the asset’s reported value is now $300,000. This helps stakeholders understand the remaining economic benefit of long-term investments while recognizing the wear and tear that assets undergo.

Financial ratios such as return on assets (ROA) and fixed asset turnover depend on accurate depreciation reporting. Misstated asset values can distort performance metrics and mislead decision-making. Properly accounting for depreciation ensures financial statements provide a clear picture of a company’s financial health.