What is the Straight Line Basis?
The straight line basis is a method used to find an asset’s loss of value after its useful lifespan. Other common methods used to calculate depreciating 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 interest amount to each accounting period. It assumes that the asset’s value diminishes equally during each accounting period.
- Straight line basis is one of the depreciation methods used to calculate the wearing out of an asset’s value over its serviceable lifespan by assuming an equal depreciation between accounting periods.
- Companies use straight line basis to extend the value of an asset over accounting periods to benefit from its non-deductible net income.
- Accountants prefer straight line basis to calculate an asset’s depreciated value because it is simple and easy to use.
Understanding the Straight Line Basis Method
Straight line basis is premised on accounting’s matching principle. The matching principle is the basis of accrual and adjustment of entries, which requires that expenses incurred are recorded in the same period as the earned revenues. As a cause and effect relation, the convention is meant to match sales and expenses to the period in which they occurred.
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, straight line basis is used to calculate depreciation expenses.
Companies use expenses incurred when a physical asset depreciates. They use the two conventions to offset an asset as an expense against taxable income over a long period. Simply put, companies can extend the value of assets over many accounting periods so that they can benefit by not making a deduction from the entire cost of net income. Although the straight line basis is frequently used due to its simplicity and ease of use, there are some limitations that affect its efficiency.
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 to get residual value at the end of its serviceable life. The value of 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. Firstly, the difference between the cost of the asset and the salvage value is calculated. The difference is then divided by the asset’s expected life to find the asset’s depreciated value. This difference is sometimes called the asset cost or depreciable base. 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. Furthermore, the company will continue to expense $950 until the book value of the asset remains $1,500. This concept is called accumulated depreciation.
Advantages and Disadvantages of Straight Line Basis
Accountants prefer straight line basis because it is more precise and renders fewer errors over an asset’s useful life compared to other depreciation methods. It is also preferred because it is simple and allocates an even rate of depreciation to every accounting period over an asset’s useful life. Straight line basis uses only three variables to calculate the decrease in value of an asset in each accounting period.
On the downside, the straight line basis method’s major pitfalls lie in its simplicity. One of the most obvious disadvantages is that the estimated value at the end of an asset’s serviceable 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 cannot be assumed.
Additionally, the straight line basis method does not factor in the rapid loss of an asset’s value within a short lifespan. At the same time, it does not take into consideration the fact that an asset is likely to appreciate when it gets older.
Straight line basis is also used in operating leases, where it is used to calculate the number of rentals due under the agreements to be written off. An operating lease does not lead to a liability or non-current effort for future rentals due under the contract being reported on a company’s financial position statement of the lease.
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