In this article, we will be explaining the declining balance depreciation method and provide an example so that you can clearly understand how it works. Unlike other depreciation methods, the salvage value is not deducted from the cost of the asset under this method. The accelerated depreciation rate is applied to the book value (i.e., undepreciated cost) of the asset at the beginning of the period. The continuous charge reduces the book value of the asset year by year and, hence, the depreciation expense.
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. As seen in the formula of declining balance depreciation above, the company needs the deprecation rate in order to calculate the depreciation. Hence, it is important for the management of the company to determine the depreciation rate that can allow the company to properly allocate the cost of the fixed asset over its useful life.
This rate is typically a multiple of the straight-line rate, offering flexibility to match the depreciation strategy to financial goals. Declining balance method of depreciation is an accelerated depreciation method in which the depreciation expense declines with age of the fixed asset. Depreciation expense under the declining balance is calculated by applying the depreciation rate to the book value of the asset at the start of the period.
Salvage value in declining balance depreciation
For example, an asset costing off balance sheet definition $10,000 with $2,000 in accumulated depreciation has a book value of $8,000. Applying a 40% double-declining rate results in a $3,200 depreciation expense for that year. This process continues annually, with the book value decreasing as depreciation accumulates.
Examples of Declining Balance Depreciation
This approach is ideal for assets like computers or machinery that rapidly lose value. The declining balance depreciation is a simple method to calculate the depreciation expense since it requires very little data points for the computation of the calculation. It’s a good method to be used for assets that lose their value quickly at the beginning of their expected useful life, such as highly technological products. The down side of this method is that the depreciation expense changes every year unlike the straight line method that has the same expense year on year. In order to become an expert in calculating depreciation, make sure you practice in various situations and you will eventually become a master in this topic. Choosing the right method of depreciation to allocate the cost of an asset is an important decision that a company’s management has to undertake.
Straight Line Depreciation Method
From year 1 to 3, ABC Limited has recognized accumulated depreciation of $9800.Since the Machinery has a residual value of $2500, depreciation expense is limited to $10000 ($12500-$2500). As such, the depreciation in year four will be $200 ($10000-$9800) rather than $1080, as computed above. Also, for Year 5, depreciation expense will be $0 as the assets are already fully depreciated. This is usually when the net book value of the fixed asset is below the minimum value that asset is required to be capitalized (which should be stated in the fixed asset management policy of the company). Depreciation allows a company to deduct an asset’s declining value, reducing the amount of income on which it must pay taxes. Its anticipated service life must be for more than one year and it must have a determinable useful life expectancy.
The 150% declining balance method is a moderate approach to accelerated depreciation, applying a rate 1.5 times the straight-line rate. For example, an asset with a ten-year useful life has a straight-line rate of 10%, which becomes 15% under this method. This variant suits assets with a moderate rate of wear and tear, such as office furniture or industrial equipment, and is recognized under MACRS for certain asset classes.
How to Calculate Straight Line Depreciation
- That can be highly beneficial for startups and other growing businesses, especially those with asset-heavy operations.
- This rate is typically a multiple of the straight-line rate, offering flexibility to match the depreciation strategy to financial goals.
- The double declining balance (DDB) method is an accelerated depreciation technique used to allocate the cost of a fixed asset over its useful life.
- The cost of an asset normally comprises depreciation and repairs and maintenance.
Additionally, the DDB method does not subtract the residual value at the beginning, unlike the straight-line method. Firstly, it results in higher depreciation expenses in the early years of an asset’s life, which reduces taxable income and, consequently, taxes owed during those years. Secondly, it better matches the expense with the asset’s usage, as many assets lose value more quickly in their early years.
Your industry, tax strategy and financial trajectory should all factor into your choice of depreciation method. A qualified professional, such as a Certified Public Accountant (CPA), can help you determine which one makes the most sense. You can calculate an asset’s straight-line depreciation rate by dividing one by its useful life.
Example 1: Double-Declining Depreciation in First Period
Companies need to opt for the right depreciation method, considering the asset in question, its intended use, and the impact of technological changes on the asset and its utility. DBM has pros and cons and is an ideal method for assets where technological obsolescence is very high. The declining balance method of Depreciation is also called the reducing balance method, where assets are depreciated at a higher rate in the initial years than in the subsequent years. Under this method, a constant depreciation rate is applied to an asset’s (declining) book value each year. This method results in accelerated depreciation and higher depreciation values in the early years of the life of an asset.
- The most common declining balance percentages are 150% (150% declining balance) and 200% (double declining balance).
- For example, a $10,000 asset with a five-year life span would be depreciated at 20%—or $2,000—per year using straight-line depreciation.
- Depending on the chosen method, this rate is multiplied by 2 for double-declining, 1.5 for the 150% method, or 1.25 for the 125% method.
- CCC purchased new machinery for the construction business at a cost of $50,000 with a salvage value of $4,000.
How to calculate depreciation expenses using reducing balance method?
A better method for depreciating assets whose utility progressively increases is the Sum of the Digits Method. Lastly, once you place an asset into service and start depreciating it with the double declining balance method, switching methods may not be easy. It only complicates your bookkeeping further, and you must file the surprisingly intensive Form 3115 to get IRS approval for the change, which isn’t guaranteed. The declining balance or reducing balance depreciation method considers the value of assets that are largely used or highly contribute to operation at the beginning and then subsequently decline.
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. Note that the depreciation in the fifth and final year is only for $1,480, rather than the $3,240 that would be indicated by the 40% depreciation rate. The reason for the smaller depreciation charge is that Pensive stops any further depreciation once the remaining book value declines to the amount of the estimated salvage value. Reducing balance method causes reported profits of a company to decline by a higher depreciation charge in the early years of an assets life.
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own.
