What is the Declining Balance Method?

Declining Balance Method Formula

Under the Declining Balance Method Formula, the depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more is computed as:

Declining Balance Method Example

Let’s understand the same with the help of examples:

Example #1

Ram purchased a Machinery costing $11000 with a useful life of 10 years and a residual valueResidual ValueResidual value is the estimated scrap value of an asset at the end of its lease or useful life, also known as the salvage value. It represents the amount of value the owner will obtain or expect to get eventually when the asset is disposed.read more of $1000. The rate of DepreciationRate Of DepreciationThe depreciation rate is the percent rate at which an asset depreciates during its estimated useful life. It can also be defined as the percentage of a company’s long-term investment in an asset that the firm claims as a tax-deductible expense throughout the asset’s useful life.read more is 20%. Depreciation as per the DBM is computed as follows:

Thus, the Machinery will depreciate over the useful life of 10 years at the rate of depreciation (20% in this case). As we can observe, the DBM results in higher depreciation during the initial years of an asset’s life and keeps reducing as the asset gets older.

Among the most common DBM is Double Declining Balance (DDB). The straight-line rate is applied to the declining balance under the Double Declining Balance (DDB) method two times. It is an ideal depreciation method for assets that quickly lose value or are subject to technological obsolescence. Under Double Declining Balance MethodDouble Declining Balance MethodThe Double Declining Balance Method is one of the accelerated methods used for calculating the depreciation amount to be charged in the company’s income statement. It is determined by multiplying the book value of the asset by the straight-line method’s rate of depreciation and 2read more the depreciation is computed by the formula:

It doesn’t always use assets’ salvage value (or residual value) while computing the depreciation. However, depreciation ends once the estimated salvage value of the asset is reached. However, in those cases where the asset has no residual value, this method will never depreciate the asset fully and is typically changed to the Straight Line Depreciation MethodStraight Line Depreciation MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more at some stage during the asset’s life.

Let’s understand the same with the help of a declining balance method example:

Example #2

ABC Limited purchased a Machine costing $12500 with a useful life of 5 years. The Machine is expected to have a salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company’s machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000.read more of $2500 at the end of its useful life.

Let’s calculate the depreciation using the Double Declining Balance 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.

Advantages

  • It results in accelerated depreciation and is a good method to record depreciation of assets that quickly lose their value or become obsolete, like computer equipment and other technology products, thereby depicting fair market value on the Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more.Due to higher depreciation in the Initial years, Net Income is reduced, which results in tax benefits due to lower tax outflow.

Disadvantages

  • It results in lower Net Income during the initial years of an asset as Depreciation is higher initially.It is not ideal for assets that don’t lose their value quickly, like Equipment and Machinery.

Differences Between Straight Line Method and Declining Balance Method

Conclusion

Choosing the right method of depreciation to allocate the costAllocate The CostCost Allocation is the procedure of recognizing & assigning costs to different cost objects like a product, department, program, customer, etc., as per the cost driver serving as the base for this process. read more of an asset is an important decision that a company’s management has to undertake. 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. However, it is important from an Investor perspective to ensure that such an accelerated depreciation method is not deployed with the intent to suppress the Income of the business (due to high depreciation) and obtain tax benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more only, which becomes evident in cases where companies make large gains on the sale of assets.

Declining Balance Method of Depreciation Video

This article has been a guide to what is the Declining Balance Method of Depreciation. Here we discuss the declining balance formula along with practical examples. Here we also discuss its advantages and disadvantages. You may learn more about accounting basics from the following articles –

  • What is Accelerated Depreciation?Accounting CycleNon-Current AssetsTangible vs Intangible Assets