Declining Balance Method of Assets Depreciation Pros & Cons
For example, if the equipment in the above case is purchased on 1 October rather than 2 January, depreciation for the period between 1 October and 31 December is ($16,000 x 3/12). This rate is applied to the asset’s remaining book value at the beginning of each year. The arbitrary rates used under the tax regulations often result in assigning depreciation to more or fewer years than the service life.
As an alternative to systematic allocation schemes, several declining balance methods for calculating depreciation expenses have been developed. It is applicable to the assets which are used for years and the usage declines with the passage of time. In this method, the book value of an asset is reduced (written down) by double the depreciation rate of the straight-line depreciation method. The declining balance method, also known as the reducing balance method, is ideal for assets that quickly lose their values or inevitably become obsolete. This is classically true with computer equipment, cell phones, and other high-tech items, which are generally useful earlier on but become less so as newer models are brought to market.
What is Double Declining Balance Depreciation?
Though various methods are available for calculating depreciation, it is arguably the best way to compute each year’s depreciation and remaining book value. A major advantage of the declining balance method of depreciation is that it matches the costs of the asset to the revenue it generates. A higher amount of depreciation is charged in the initial year when the asset is more productive. On the other hand, a lower amount is charged in the later years of the asset’s life. The declining balance method is useful for recognized accelerated usage levels for equipment that tends to be used heavily.
Under the declining balance method, depreciation is charged on the book value of the asset and the amount of depreciation decreases every year. The declining balance method is commonly used for assets that lose their value quickly, such as computers and other technology equipment. It’s also used when the benefits provided by the asset are expected to be greater in the earlier years of its life. Now let us take an example where equipment was purchased by Company B on 30th June 2020 for $300, and the depreciation rate to be charged on this asset is 40%. The declining balance method is also known as the reducing balance method. When applying the double-declining balance method, the asset’s residual value is not initially subtracted from the asset’s acquisition cost to arrive at a depreciable cost.
Advantages of Declining Balance Method of Depreciation
For example, if the straight-line rate is 20%, the double declining balance method would use a rate of 40%. Under the declining depreciation method, a greater depreciation is charged in the initial years of the asset’s life. This is a rational approach because the asset’s efficiency is higher in the initial years, and efficiency reduces as the asset’s life increases. Thus, it can be said that this method of charging depreciation is the most appropriate and widely used.
For example, laptop computers are typically only used for a few years, after which faster laptops become available and the older ones are more likely to be replaced. More commonly, these methods are used to reduce the amount of taxable income in the near term, so that a firm’s tax liability can be pushed out into later periods. Thus, a declining balance method can improve the cash flow of a business by reducing the amount of taxes payable in the short term. Under the declining balance method, yearly depreciation is calculated by applying a fixed percentage rate to an asset’s remaining book value at the beginning of each year.
Finance Strategists is a leading financial literacy non-profit organization priding itself on providing accurate and reliable financial information to millions of readers each year. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. These points are illustrated in the following schedule, which shows yearly depreciation calculations for the equipment in this example. This is when that year’s depreciation is limited to the amount that will reduce the asset’s book value to its residual value.
Under the declining balance methods, the asset’s salvage value is used as the minimum book value; the total lifetime depreciation is thus the same as under the other methods. When large amounts of depreciation are being recognized early in the life of an asset, this means that the carrying amount of the asset is severely reduced within a short period of time. If the asset is sold within a few years of its acquisition, this can result in the recognition of a large gain, since the carrying amount of the asset is likely to be well below its market value. When this happens, the gains being recognized do not mean that the company is getting great prices on the assets it sells – only that their carrying amounts are quite low. Financial accounting applications of declining balance are often linked to income tax regulations, which allow the taxpayer to compute the annual rate by applying a percentage multiplier to the straight-line rate. Employing the accelerated depreciation technique means there will be smaller taxable income in the earlier years of an asset’s life.
Current book value is the asset’s net value at the start of an accounting period, calculated by deducting the accumulated depreciation from the cost of the fixed asset. Residual value is the estimated salvage value at the end of the useful life of the asset. And the rate of depreciation is defined according to the estimated pattern of an asset’s use over its useful life. In this formula, the depreciation rate is usually a multiple of the straight-line rate.
All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Note that the double-declining multiplier yields a depreciation expense for only four years. Also, note that the expense in the fourth year is limited to the amount needed to reduce the book value to the $20,000 salvage value. In the second year, depreciation is calculated in a regular way by multiplying the remaining book value of $36,000 ($40,000 — $4,000) by 40%.
They determine the annual charge by multiplying a percentage rate by the book value of the asset (not the depreciable basis) at the beginning of the year. Let us consider an example where a machine was purchased by Company A for $200 on 1st January 2020 for use in producing its goods. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.
Declining Balance Method
If this asset is still valuable, its sale could portray a misleading picture of the company’s underlying health. Though complex, the declining balance method of depreciation is used widely in organizations for computing depreciation to be charged on fixed assets. It is a popular tool to determine the quantum of benefits an asset can fetch throughout its useful life.
- In the Declining Balance method, LN calculates each
year’s total depreciation by applying a constant percentage to the asset’s net
- Under the declining balance method, depreciation is charged on the book value of the asset and the amount of depreciation decreases every year.
- Because twice the straight-line rate is generally used, this method is often referred to as double-declining balance depreciation.
- The declining balance technique represents the opposite of the straight-line depreciation method, which is more suitable for assets whose book value drops at a steady rate throughout their useful lives.
A declining balance method is used to accelerate the recognition of depreciation expense for assets during the earlier portions of their useful lives. This leaves less depreciation expense to be recognized later in their useful lives. To calculate depreciation under a declining method, multiply the book value of an asset at the beginning of the fiscal year by a multiple of the straight-line rate of depreciation. Examples of declining balance methods are the 150% declining balance method and the double declining balance method. Declining balance is a method of computing depreciation rate for the value of an asset.
The declining balance method is also known as reducing balance method or diminishing balance method. It is an accelerated depreciation method that results in larger depreciation amounts during the earlier years of an assets useful life and gradually lower amounts in later years. The declining balance method is a type of accelerated depreciation method that is used to allocate the cost of a tangible asset over its useful life. If a company often recognizes large gains on sales of its assets, this may signal that it’s using accelerated depreciation methods, such as the double-declining balance depreciation method. Net income will be lower for many years, but because book value ends up being lower than market value, this ultimately leads to a bigger gain when the asset is sold.
Calculating Declining Balance depreciation
Consider another example of furniture purchased for $500 on 1st October 2020. Calculate depreciation for 10 years on this asset along with the book value at the end of each year. If the asset for which you are calculating depreciation
contains an averaging convention, LN adjusts the depreciation expense for the first half year, quarter,
or month calculation. Is a form of accelerated depreciation in which first-year depreciation is twice the amount of straight-line depreciation when a zero terminal disposal price is assumed. Because twice the straight-line rate is generally used, this method is often referred to as double-declining balance depreciation.