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. In this case, the depreciation rate in the declining balance method can be determined by multiplying the straight-line rate by 2. For example, if the fixed asset’s useful life is 5 years, then the straight-line rate will be 20% per year. Likewise, the depreciation rate in declining balance depreciation will be 40% (20% x 2).

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The four depreciation methods include straight-line, declining balance, sum-of-the-years’ digits, and units of production. The declining balance method formula shown below is used to calculate the declining balance rate (DB Rate). 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. Reducing balance method causes reported profits of a company to decline by a higher depreciation charge in the early years of an assets life.

It’s ideal for assets that quickly lose their value or inevitably become obsolete. This is classically true with computer equipment, cell phones, and other high-tech items that are generally useful earlier on but become less so as new models are brought to market. An accelerated method of depreciation ultimately factors in the phase-out of these assets. However, the company needs to use the salvage value in order to limit the total depreciation the company charges to the income statements. In other words, the depreciation in the declining balance method will stop when the net book value of the fixed asset equals the salvage value. Although any rate can be used, the straight-line rate is commonly used as a base to determine the depreciation rate for the declining balance method.

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Reducing Balance Method is appropriate where an asset has a higher utility in the earlier years of its life. Computer equipment also becomes obsolete in a span of few years due to technological developments. Using reducing balance method to depreciate computer equipment would ensure that higher depreciation is charged in the earlier years of its operation. The double-declining method involves depreciating an asset more heavily in the early years of its useful life. A business might write off $3,000 of an asset valued at $5,000 in the first year rather than $1,000 a year for five years as with straight-line depreciation. The double-declining method depreciates profit and loss aptitude questions and answers assets twice as quickly as the declining balance method as the name suggests.

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. The units of production method assigns an equal expense rate to each unit produced. It’s most useful where an asset’s value lies in the number of units it produces or in how much it’s used, rather than in its lifespan. The formula determines the expense for the accounting period multiplied by the number of units produced. 150% declining balance depreciation is calculated in the same manner as is double-declining-balance depreciation, except that the rate is 150% of the straight-line rate. Current book value is the asset’s net value at the start of an accounting period.

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Because twice the straight-line rate is generally used, this method is often referred to as double-declining balance depreciation. 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. This formula is best for small businesses seeking a simple method of depreciation. Referring to Example 1, calculate the depreciation of the asset for the second year of its life.

At the end of 4 years the net book value is 1,296 which equals the salvage value of the replacement cost definition asset. The company ABC has the policy to depreciate the machine type of fixed asset using the declining balance depreciation with the rate of 40% per year. The machine is expected to have a $1,000 salvage value at the end of its useful life. A declining balance method accelerates depreciation so more of an asset’s value can be recorded earlier in its useful life.

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. 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. Depreciation is an accounting method that companies use to apportion the cost of capital investments with long lives, such as real estate and machinery. 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. Thus, the Machinery will depreciate over the useful life of 10 years at the rate of depreciation (20% in this case).

Effects of the Declining Balance Method

There are four allowable methods for calculating depreciation, and which one a company chooses to use depends on that company’s specific circumstances. Small businesses looking for the easiest approach might choose straight-line depreciation, which simply calculates the projected average yearly depreciation of an asset over its lifespan. Since different assets depreciate in different ways, there are other ways to calculate it. Declining balance depreciation allows companies to take larger deductions during the earlier years of an assets lifespan.

This is due to the straight-line rate can be easily determined through the estimated useful life of the fixed asset. Also, this yearly rate of depreciation is usually in line with the industry average. The following examples show the application of the double and 150% declining balance methods to calculate asset depreciation. For example, if the fixed asset management policy sets that only long-term asset that has value more than or equal to $500 should be recorded as a fixed asset. Those that have value less than $500 should be recorded as expenses immediately.

This formula is best for production-focused businesses with asset output that fluctuates due to demand. Usually the calculation gives an answer to a number of decimal places, it is normal to round to the nearest whole percentage, as the salvage value can never be accurately determined. 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.

1. Companies have several options for depreciating the value of assets over time, in accordance with GAAP.
2. An accelerated method of depreciation ultimately factors in the phase-out of these assets.
3. 150% declining balance depreciation is calculated in the same manner as is double-declining-balance depreciation, except that the rate is 150% of the straight-line rate.
4. The depreciation method used should therefore charge a higher portion of the cost of such assets in the earlier years which is why reducing balance method is most appropriate.
5. Finance Strategists has an advertising relationship with some of the companies included on this website.

The declining balance method is more difficult for the accountant to calculate. This means that it takes more accounting effort, and is also more prone to calculation errors. In addition, the result is unusually low asset carrying amounts, which can give the impression that a business is operating with a lower fixed asset investment than is really the case. With declining balance methods of depreciation, when the asset has a salvage value, the ending Net Book Value should be the salvage value.

Declining balance depreciation is the type of accelerated method of depreciation of fixed assets that results in a bigger amount of depreciation expense in the early year of fixed asset usage. In this case, the company can calculate decline balance depreciation after it determines the yearly depreciation rate and the net book value of the fixed asset. While the straight-line depreciation method is straight-forward and most popular, there are instances in which it is not the most appropriate method. Assets are usually more productive when they are new, and their productivity declines gradually due to wear and tear and technological obsolescence. For true and fair presentation of financial statements, matching principle requires us to match expenses with revenues. Declining-balance method achieves this by enabling us to charge more depreciation expense in earlier years and less in later years.

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. 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.

Under the declining balance method, depreciation is charged on the book value of the asset and the amount of depreciation decreases every year. The straight-line depreciation method simply subtracts the salvage value from the cost of the asset and this is then divided by the useful life of the asset. The annual straight-line depreciation expense would be $2,000 ($15,000 minus $5,000 divided by five) if a company shells out $15,000 for a truck with a $5,000 salvage value and a useful life of five years. Employing the accelerated depreciation technique means there will be lesser taxable income in the earlier years of an asset’s life. The true purpose of calculating a depreciation expense is to allow the business to set aside profits in order to be able to replace the fixed asset at the end of its useful life. 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).