what is the formula to calculate straight-line depreciation on an income property?

What is depreciation?

Depreciation is a mode to business relationship for the reduction of an asset'southward value equally a consequence of using the asset over time. Depreciation mostly applies to an entity's owned fixed assets or to its right-of-use (ROU) assets arising from finance leases for lessees.

Depreciation expense allocates the toll of a company'southward use of an nugget over its expected useful life. The expense is an income statement line item recognized throughout the life of the asset as a "non-greenbacks" expense.

Accumulated depreciation is the associated residual sheet line particular for depreciation expense. Depreciation expense is recorded equally a debit to expense and a credit to a contra-asset account, accumulated depreciation. The contra-asset account is a representation of the reduction of the fixed nugget's value over time. The accumulated depreciation account has a normal credit residue, as it offsets the fixed asset, and each time depreciation expense is recognized, accumulated depreciation is increased. An nugget's net book value is its toll less its accumulated depreciation.

Accumulated depreciation is carried forward on the residuum sheet until the related asset is disposed of and reflects the total reduction in value of the nugget over time, or in other words, the total amount of depreciation expense recorded in previous periods.

Depreciation methods

Nether US GAAP, in that location are four methods of calculating depreciation a company may use:

1. Straight-line method of depreciation
2. Double-declining balance method
3. Sum-of-the-years'-digits depreciation method
4. Units of production depreciation method

Beneath we volition describe each method and provide the formula used to calculate the periodic depreciation expense.

Straight-line method of depreciation

The direct-line method of depreciation is the most mutual method used to summate depreciation expense. It is the simplest method considering it as distributes the depreciation expense over the life of the asset.

The only inputs required to calculate depreciation expense using the straight-line depreciation method are:

• The cost of the asset: the amount the business paid for the asset or for the use of the asset
• The salvage value: sometimes chosen scrap value or residue value, is the gauge of the corporeality the company expects to receive for the asset if sold at the end of its useful life
• The useful life of the asset: the estimated corporeality of time the asset is expected to exist functionally used before information technology needs to be replaced or disposed

Below we have provided the formula to summate direct-line depreciation expense:

Because this method is the most universally used, nosotros volition present a total example of how to account for straight-line depreciation expense on a finance charter later in our article.

Alternative depreciation methods

While the straight-line depreciation method is typically used, other methods of depreciation are adequate for businesses to use under United states of america GAAP to calculate depreciation expense.

Double-declining residuum method

The double-declining balance method of depreciation does non recognize depreciation expense evenly over the life of the asset, merely rather, takes into account that avails are generally more than productive the newer they are, and become less productive in their later years. Considering of this, the double-failing balance depreciation method records higher depreciation expense in the beginning years and less depreciation in subsequently years. This method is commonly used past companies with avails that lose their value or go obsolete more quickly.

To calculate depreciation using this method, a charge per unit of depreciation is calculated and multiplied past the volume value each year. The formula to calculate depreciation expense using this method is every bit follows:

The term "double-declining balance" is due to this method depreciating an asset twice every bit fast as the straight-line method of depreciation. The "two" in the formula represents the dispatch of deprecation to twice the straight-line depreciation amount. However, when using the double-declining balance method of depreciation, an entity is not required to simply accelerate depreciation by two. They are able to cull an acceleration factor appropriate for their specific state of affairs.

Sum-of-the-years'-digits depreciation method

Similarly to the double-failing balance method, the sum-of-the -years'-digits method accelerates depreciation, resulting in college depreciation expense in the earlier years of an nugget'southward life and less in later years.

This method is calculated by adding up the years in the useful life and using that sum to summate a percentage of the remaining life of the nugget. The percentage is then applied to the cost less salvage value, or depreciable base, to summate depreciation expense for the flow.

For example, if an nugget has a useful life of v years, summing the digits of the five years of the asset's useful life looks like this: ane + two + iii + 4 + 5 = xv. Each year, the depreciable base is multiplied by the percent of the remaining useful life to determine the annual depreciation expense. The annual expense is and so allocated evenly over the year in each fiscal menses.

For further clarity, for an asset with a 5-year useful life, the annual depreciation expense for the kickoff year would be one third (⅓ = v / 15) of the nugget's value. In yr two the annual depreciation expense percentage would be 4/15 and in year iii the percentage would be one fifth (⅕ = 3/15), and so on.

Units of product depreciation method

Unlike the other methods, the units of production depreciation method does not depreciate the nugget solely based on time passed, but on the units the asset produced throughout the period.

This method first requires the business to estimate the total units of product the asset will provide over its useful life. Then a depreciation amount per unit is calculated by dividing the cost of the nugget minus its salvage value over the total expected units the asset will produce. Each menstruation the depreciation per unit charge per unit is multiplied by the actual units produced to summate the depreciation expense.

Below are the ii formulas used in the units of production depreciation method:

Regardless of the depreciation method used, the full depreciation expense (and accumulated depreciation) recognized over the life of any asset will be equal. However, the rate at which the depreciation is recognized over the life of the asset is dictated by the depreciation method chosen.

Example: Straight-line depreciation with a finance lease

At present, let's consider a full example of a finance charter to illustrate straight-line depreciation expense.

Reed, Inc. leases equipment for annual payments of $100,000 over a ten year charter term. Payments are due in advance on January ane of each year.

This charter qualifies every bit a finance charter because it is written in the agreement that ownership of the equipment automatically transfers to Reed, Inc. (the lessee) when the charter terminates. To evaluate the lease nomenclature, nosotros used the capital vs. operating lease criteria examination.

• Payments: $100,000 annually in advance
• Save value: $0
• Lease term: x years
• Lease starting time appointment: 1/one/2022
• Charter stop date: 12/31/2031
• Useful life of equipment: x years

Reed, Inc. also evaluates the incremental borrowing charge per unit for the lease to be 4%. For this example we will assume no other lease incentives, accruals, or initial straight costs are applicable for this lease.

Using the facts and circumstances presented, we can apply LeaseQuery's present value calculator to summate the present value of the lease payments. This is the value we volition record for the ROU asset and what will be depreciated. In order to do so, input annual payments of $100,000, a ten year lease term, and a 4% disbelieve rate. At beginning, the lessee records a charter nugget and lease liability of $843,533.

Initial journal entries

To recognize the ROU asset and lease liability at charter kickoff, the lessee makes the following entry:

Straight-line depreciation expense calculation

In our explanation of how to calculate directly-line depreciation expense above, we said the calculation was (cost – salvage value) / useful life. For a finance lease, it is important to distinguish whether the agreement is a "stiff form" or a "weak form" finance lease to decide whether the useful life or the charter term is used as the depreciable base term.

A strong form finance lease is ane that has a transfer of buying, a deal buy option (BPO), or a purchase choice the lessee is reasonably certain to exercise. With a strong form lease, the asset is depreciated over the useful life of the nugget equally it is causeless the lessee will own the asset at the stop of the lease term. For weak form finance leases where the lessor retains buying of the nugget at the end of the lease term, the asset is depreciated over the shorter of the useful life or the lease term.

In our example, the championship transfers, which means at the end of the lease term the lessee will own the nugget and go along depreciating information technology. Nevertheless, the useful life of the equipment in this example equals the lease term (10 years) and then at the end of the lease, the asset will exist depreciated to $0.

To calculate the straight-line depreciation expense, the lessee takes the gross asset value calculated above of $843,533 divided by ten years to calculate an almanac depreciation expense of $84,353.

Below is the acquittal schedule for both the ROU nugget and the lease liability:

Annual journal entries

Throughout the year, the lessee recognizes straight-line depreciation evenly per month every bit a reduction in the asset value recorded to the depreciation expense account and accumulated depreciation. The lessee makes the post-obit entry in Twelvemonth ane to recognize the $100,000 payment and annual depreciation of $84,353:

In subsequent periods, the lessee will brand periodical entries to recognize the depreciation expense on the nugget, the reduction to the charter liability'due south principal residue, and involvement expense accrual on the outstanding liability. For example, in year 2, the lessee makes the following entry:

As you tin see from the amortization tabular array, this continues until the finish of Year 10, at which point the total asset and liability balances are $0. Further, the total value of the asset resides in the accumulated depreciation account as a credit. Combining the total asset and accumulated depreciation amounts equals a net volume value of $0.

Summary

Depreciation expense is the recognition of the reduction of value of an nugget over its useful life. Multiple methods of accounting for depreciation expense exist, merely the straight-line method is the most normally used. In this commodity, nosotros covered the different methods used to calculate depreciation expense, and went through a specific example of a finance charter with directly-line depreciation expense.

The calculations required to create an amortization schedule for a finance lease can be complex to manage and track inside Excel. A software solution such as LeaseQuery can aid in the calculation and management of depreciation expense on your finance leases.

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