What is the Straight Line Basis?
The straight line basis is a method used to determine an asset’s rate of reduction in value over its useful lifespan. Other common methods used to calculate depreciation expenses of fixed assets are sum of year’s digits, double-declining balance, and units produced.
Straight line basis is the simplest technique used to compute the value loss of an asset over its useful life. Also called straight line depreciation, straight line basis charges an equal expense amount to each accounting period. It assumes that the asset’s value diminishes equally over each accounting period during its useful life.
- Straight line basis is a depreciation method used to calculate the wearing out of an asset’s value over its serviceable lifespan by assuming an equal depreciation expense each accounting period.
- Companies use the straight line basis to expense the value of an asset over accounting periods to reduce net income.
- Accountants prefer the straight line basis to calculate an asset’s depreciated value because it is simple and easy to use.
Understanding the Straight Line Basis Method
Recording depreciation and amortization is in accordance with accounting’s matching principle. The matching principle is the basis of accrual accounting, which requires expenses that are incurred to be recorded in the same period as the revenues earned. The convention is meant to match sales and expenses to the period in which they occurred, as opposed to when payment was made or collected.
Depreciation and amortization are the conventions companies use to attain the matching objective. Intangible assets are only amortized if they have limited useful years. Straight line basis is also used to amortize fixed and intangible assets, such as software and patents. Depreciation of fixed assets is similar to amortization, and in both, the straight line basis is commonly used to calculate the expense amount.
Companies use depreciation and amortization to expense an asset over a long period of time, as opposed to deducting the full cost of the asset in the period it was purchased. The latter being done under the cash basis of accounting. The straight line basis simply allocates the expense equally into each period of its useful life, which smooths the expense and ultimately net income.
How to Calculate the Straight Line Basis
Companies use the straight line basis method to determine the amount to be expensed over accounting periods. To calculate the depreciation of an asset, an asset’s salvage value is deducted from its purchase price the difference is then divided by the estimated useful years of the asset.
Assume that Company X purchases an asset at the cost of $20,500. The asset’s life expectancy is 20 years, with $1,500 as the estimated salvage value. First, the difference between the purchase price of the asset and the salvage value is calculated. This difference is sometimes called the depreciable base. The difference is then divided by the asset’s expected life to find the annual depreciation expense amount. The asset’s straight line depreciation is:
Depreciable Base = $20,500 – $1,500 = $19,000
Straight Line Depreciation = $19,000/20 = $950
Thus, Company X only needs to expense $950 instead of writing off the asset’s full cost in the current accounting period, which is what would happen under the cash basis of accounting. Furthermore, the company will continue to expense $950 annually until the book value of the asset reaches the salvage value of $1,500.
Advantages and Disadvantages of Straight Line Basis
Accountants prefer the straight line basis because it is easy to calculate and understand. The method allocates an even amount to each accounting period over the asset’s useful life making it a predictable expense, and allows for the smoothing of net income.
On the downside, the straight line basis method’s major pitfalls lie in its simplicity. One of the most obvious disadvantages is that the asset’s useful life is based on guesswork. For example, the risk of an asset becoming obsolete earlier than anticipated due to the transformative nature of innovative technology is not considered.
Additionally, the straight line basis method does not factor in the actual physical rapid loss of an asset’s value in the early years of its life. At the same time, it does not take into consideration the fact that an asset will likely require more maintenance as it ages.
Straight line basis is also applied in operating leases, where it is used to calculate the amount of rental payments due under a lease agreement. The payments will be equal for each period until the end of the lease..
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