The Double Declining Balance Method of Depreciation
Did you buy a computer or an equipment today? Wonder what if you had to sell it off in a year or two? How much would you get? No matter what you own, it won’t be of the same value tomorrow as it is today.
While it’s no secret that depreciation happens, when it comes to taxes, you might be better off selecting one method over the other when it comes to calculating the depreciation value. And that’s what this article will be all about.
Before we start with the whole Double Declining Balance Method though, let’s look into what depreciation is all about. If you are new to the term, here is what you need to know; Depreciation is the reduction of a fixed asset’s registered cost using specific methods until the value of the asset falls extremely low.
When we say ‘fixed assets,’ we mean buildings, office equipment, furniture, machinery and more. However, although the land is also an asset, we do not include it in the list because it is an asset that cannot be depreciated. The value of an asset such as land appreciates over time unless there are other environmental reasons for devaluation.
Here is a video that talks about it in detail.
TYPES OF DEPRECIATION
To determine the value of an asset, you have different types of depreciation methods and formulas. Few common ones are as below:
- Straight-Line Depreciation Method – This is considered one of the simplest methods of all. In this method, you will make the simple allocation of the depreciation rate every year during the useful life of an asset.
Formula: Annual Depreciation Expense = (Cost of Asset/Remaining Value)/Useful life of the asset.
- Unit of Production Method – This method is used to depreciate the asset based on the number of hours the asset is used, or the total production of units during its useful life. You may say that the unit of production method calculates the output proficiency of the asset in question, instead of considering the number of years used.
Formula: Per Unit Depreciation = (Cost of Asset – Remaining Value)/Units produced during its functioning life
- Double Declining Method – Double declining method is an accelerated depreciation method. In this method, companies take maximum depreciation charges in the initial years of useful life of the asset to lower profits in the income statements, instead of the later years when the asset loses its value. The lowering of profits in the initial years enables lower income taxes during that time.
Formula: Depreciation = 2 X Straight Line Depreciation % X Book Value* (beginning of the accounting period)
- Sum of the Years’ Digits Depreciation Method – Quite close to the declining balance depreciation method, this method also results in accelerated depreciation during the useful early life of an asset. For assets that can produce more in the initial years but slows down in the future, this method is more useful compared to the straight line depreciation.
Formula: Depreciation for the Year = (Cost of Asset – Salvage Value) X Factor (every year)
*Book Value – An asset’s book value is its worth at a given point in time. It is equal to the asset’s cost basis, minus the accumulated depreciation amount.
The formula to evaluate an asset’s book value: Book Value = Asset’s cost basis – Accumulated depreciation
The benefit and reasons for each method are different, and using the right one that suits your business depends on the type of asset you have. While the straight line depreciation method sounds the most convenient to use with streamlined accounting calculations, the declining balance method provides you a precise accounting of the asset’s value.
In a nutshell, depending on the nature of the assets and your company’s choice, you can pick one best-suited depreciation method.
PARTIAL YEAR DEPRECIATION
The purchase of an asset might not always happen at the beginning of the accounting year. Sometimes, you might have to purchase some assets in the middle of a fiscal year as well, and this complicates the calculation a bit.
However, depending on what accounting methods you apply, depreciation on these sort of assets can be treated differently. One of the methods would be partial year depreciation, in which the depreciation is evaluated exactly when the asset is in use and the convention in which the depreciation falls.
First, you will need to determine the asset’s depreciation. Check if it was used for the entire fiscal year. By using the asset’s existing depreciation schedule, you can determine the depreciation of the asset.
Further, to extract the amount of the asset’s monthly depreciation, divide the total anticipated depreciation for the year by 12. Multiply this amount by the number of months of the fiscal that the asset was owned. The result will provide you with a total amount of depreciation for a partial year.
Note: Each asset you purchase will be depreciated differently. You will need to be mindful of which method you are using to depreciate an asset before you start your evaluation.
WHY SHOULD BUSINESSES RECORD DEPECIATION?
So, now that we know what depreciation is, and different kinds of methods of determining the value of assets are, here is why businesses should record depreciation. Understanding accounting concepts will help your business do more.
As explained above, the purpose of depreciation is to match the revenue generated by an asset for the business, with the cost of the fixed asset during its useful life. Further, the cost of the asset is moved to the income statement from the balance sheet during that time.
What if we don’t use depreciation in accounting? In such circumstances, we will be required to charge whatever assets we buy, immediately after.
The drawback of not using depreciation in accounting also leads to an overstatement of assets and net income in the balance sheet and income statement respectively. Other repercussions are that the cost of the fixed asset isn’t considered while setting the sales prices, and since the established prices won’t be high enough, the cost of the fixed asset may not be covered as a result.
WHAT IS A DOUBLE DECLINING BALANCE METHOD?
The double declining balance depreciation method is used for accounting the expense of a long-term asset. This method is an enhanced form of depreciation that is recognized during the initial few years of the fixed assets’ useful life. Some companies use this method to carry forward the taxes to future years, which is known as double declining balance depreciation.
This method also takes the depreciation charges in these initial years and lowers profits on the income statement, instead of considering those later. Reason being, most of the assets loses its value after some time.
HOW DOES DOUBLE DECLINING DEPRECIATION WORK?
As per the GAAP (Generally Accepted Accounting Principles), public companies record expenses in the same period as the revenue generated from those expenses. For example, if a public company has bought an expensive asset and will be using it for several years, the entire asset expense is not deducted in the year of its purchase. The deduction is divided into many years.
This is beneficial for assets that lose its value over a period, because though the depreciation expense of the asset might be larger in its initial life, but it will become smaller later.
For example, let’s assume you buy a machine for $50,000. You’ll expect it to run for ten years, and estimate a salvage value of $5,000. Under the straight-line depreciation method, your company will deduct $4,500 for ten years ($50,000 – $5,000/10). With the double declining balance method, the deduction will be 20% of $50,000 ($10,000) in the first year, 20% of $40,000 ($8,000) in the second and so on.
HOW TO CALCULATE DEPRECIATION UNDER THE DOUBLE DECLINING METHOD?
Being an entrepreneur comes with its risks. To be able to apply the double declining depreciation formula, you are required to know the asset’s useful life and price first.
By dividing 100% by the asset’s useful life (in no. years) you get the asset’s straight-line depreciation rate. Further, by multiplying that rate by two, you’ll get you double declining depreciation rate. With this method, you’ll see that the depreciation will continue until the asset’s salvage value.
The salvage value of an asset is the resale value that you can estimate by the end of the asset’s useful life. To calculate the cost of an asset that will depreciate, you can take the cost of the fixed asset and then minus the salvage value.
To summarize we may look at the below pointers:
- During the time of purchase of an asset, you’ll need to determine the original cost
- Determine the asset’s salvage value (the selling value of the asset once it’s useful life is over)
- Determine the asset’s useful life
- Evaluate the asset’s depreciation rate (1/useful life)
- To find out the depreciation expense, and then multiply the book value of the period by twice the depreciation rate
- Deduct this from the beginning value for the ending period value
- Repeat these steps to reach the salvage value
For example: If you have an asset that values $50,000, you’ll estimate the salvage value to be around $5,000 in five years, by the time you are ready to sell it. That would mean, you will depreciate $45,000 over these many years. You will sell the asset for $5,000, and remove the asset from your accounting reports.
Here are two formulas to calculate straight line and double declining depreciation rates:
- Straight line depreciation rate = depreciation expense/depreciable base
- Double declining depreciation rate = straight line depreciation rate X 2
WHY WOULD A COMPANY USE DOUBLE-DECLINING DEPRECIATION ON ITS FINANCIAL STATEMENTS?
You need to take a look at the economics basics to understand and answer the question. Using double declining balance depreciation on the financial statements allows a constant blend of both depreciation expense and maintenance and repairs expense, during the asset’s useful life.
During the useful life of an asset, the repairs and maintenance expense is generally low therefore the depreciation expense is high. As time passes, the repairs and maintenance expense will rise, leading to lowered depreciation expense.
In such cases, the company reports lower net income during the useful life of the asset, which is pretty early and is mostly not deemed acceptable.
ADJUSTING DEPRECIATION CHARGES ON BALANCE SHEET, INCOME STATEMENT AND CASH FLOW STATEMENT
To understand how to adjust the depreciation charges on your balance sheet, income statement and cash flow statement, let us take an example of a machine that you purchased for a vital purpose in your company:
- If the cost of the machine is $50,000; the cash and equivalents will be reduced to that amount and will be moved to property, plant and equipment section in the balance sheet.
- Right then, an outflow of the $50,000 will be visible in the cash flow statement as well.
- Now, $12,500 is going to be charged to the income statement as depreciation expense for the first year, $10,000 in the second and this will continue for 3 – 4 years more. Though you’ll have already paid for the machinery in full during the time of purchase, however, the expense will be distributed over time.
- With every passing year, the depreciation expense will be added to property, plant and equipment section, to reduce any value of the asset (this is also known as accumulated depreciation). As per the above example, after the first year, the accumulated depreciation will be $12,500, $10,000 in the second and so on.
- Once the machine’s useful life is over, the carrying value of the asset will be very less. You might as well sell the machine, and whether profit or loss, this salvage value of the machine will be hence recorded in the income statement. The amount received on selling the machine is the cash inflow in the cash flow statement, and this will be registered in the cash and equivalent section in the balance sheet
RECORDING DOUBLE DECLINING BALANCE DEPRECIATION FOR ACCOUNTING
Recording your depreciation every month will keep your financial statements updated. As and when you register the depreciation of an asset, the depreciation expense and accumulated depreciation along with the net value of your fixed assets will show in the profit & loss statement and your balance sheet respectively. You will be required to record these expenses in a journal entry.
To prove that you own the fixed assets, you’ll need to own enough documentation, like title documentation or contracts, purchase receipts, and others as proof. Along with that, to track each asset, you will also need to create a depreciation schedule.
You might need to focus on this especially if the amount of depreciation you log in the accounting, varies from the one that is logged for tax purpose.
What is a Depreciation Schedule?
A depreciation schedule breaks down a firm’s long-term asset’s depreciation. This is a calculation of the depreciation expense for the assets you purchased and then distributes the cost over the useful life of those assets. These schedules are not just for computing the expense but also to track the starting and ending accumulated depreciation.
This schedule allows a firm to track its long-term assets and analyze the depreciation over time. You may conclude saying that it’s a description of the assets you purchase, it’s purchase date, cost, it’s useful life and its salvage value.
Also, the depreciation schedule provides information on the method of depreciation, the current year’s depreciation, accumulative depreciation from the purchase date till today and the net book value of the asset.
What is an Accumulated Depreciation? – Accumulated depreciation is a fixed asset’s total depreciation, that is charged to expense from the time it was purchased and was used. An accumulated depreciation account is a credit balance asset account; which means it will show on the balance sheet as a reduction from the fixed asset’s gross amount.
The accumulated depreciation amount increases over time, as the depreciation is charged against the fixed assets. The actual cost of the asset is the gross cost, whereas the actual cost of the asset minus the accumulated depreciation amount (and any damage) is the asset’s net cost (carrying amount).
When the asset is off its useful life, and you are planning to sell it, the accumulated depreciation amount is reversed, along with the actual cost of the asset. This eliminates all the record of the asset from the balance sheet of your company.
ADVANTAGES OF USING THE DOUBLE DECLINING BALANCE METHOD IN ACCOUNTING
We have constantly reiterated on double declining balance method and also compared it to the straight line depreciation method. So, below are a few points, to sum up why it’s advantageous to use the double declining balance method in accounting.
- Double Declining Balance – This method uses the depreciation rate to double the straight line depreciation rate. Let us give you an example of that. If the straight line depreciation rate for a 5years asset is 10% each year, using the double declining balance method, the depreciation rate is doubled to 20%. Further, the distributed depreciation expense is extracted by using the depreciation rate to multiply the depreciation base.
- Matching Asset Value – When you purchase an asset, you can rest assured that the asset will provide you with optimal usability, at least during the initial years. For example, any technically sophisticated device may go outdated as and when new products launch. The device might not support the latest requirement, and this could happen within a few years. Since the device was latest during the time of purchase, it will provide you with optimal usage in the initial years.
- Depreciation expense is meant to be a fixed asset’s cost distribution so that the actual benefit of the asset’s usage is reflected in the same period.
- Maximizing Tax Deduction – As we keep mentioning, the initial years of an asset’s usage adds more value to a company and generates better profits and revenue compared to later years. When this depreciation expense is evenly distributed, it might not help a company when it is used for tax deduction. In that case, companies need to apply the double declining balance method that gives higher depreciation expenses distributed in the initial years, to balance higher profits and revenues during the same period.
- Balancing Maintenance Costs – The value of every asset drops with passing years and will require plenty of quality maintenance to keep it up-and-running for a long time. These costs may be deducted from the company’s profits. In these type of scenarios, companies opt to distribute minimal depreciation expenses for the later years, to avoid adding more cost deductions to reduce profits.
The double declining balance method distributes these depreciation expenses in a declining method for the later years to balance the increased maintenance expenses, with the least depreciation expenses in the same period.
Although double declining balance isn’t used for tax purposes, a lot of companies apply this method for their internal accounting. Depreciation helps your accounts if you are planning on purchasing expensive assets.
This method represents the value of electronics and cars precisely compared to other methods. It’s because vehicles, devices, furniture and some other types of machinery lose value pretty quickly.
DISADVANTAGES OF USING THE DOUBLE DECLINING BALANCE METHOD IN ACCOUNTING
Now that we learned about the advantages, below are a few disadvantages as well to consider before we move further. The double declining balance method also has few drawbacks over the straight-line depreciation method:
- Compared to the simple straight line depreciation method, the double declining balance method is a little complicated.
- Since the majority of your company’s assets will last more and will be used constantly during their useful life, depreciating the value at an accelerated rate isn’t sensible. Also, it might not show the use of the assets precisely.
- Your company will not be as profitable later as in the early years. Therefore, it won’t be easy to gauge the operating profit of the company.
When we talk about the term ‘depreciation,’ it’s understood that it is a method that reduces a fixed asset’s registered cost until the value of the asset falls extremely low. If you purchased a truck for delivery of your goods from one place to another, look at how you will be using the truck to sell the goods.
You can assume the expense to charge on both the truck’s worth by the end of its useful life and its lifetime. These assumptions will affect the book value of the asset as well as the net income, and will also influence the earning of the asset after selling (if you would), for profit or loss compared to the book value.