What is the Declining Balance Method?
Declining Balance Method of Depreciation also called as reducing balance method where assets is depreciated at a higher rate in the intial years than in the subsequent years. Under this method, a constant rate of depreciation is applied to an asset’s (declining) book value each year. This method results in accelerated depreciation and results in higher depreciation values in the early years of the life of an asset.
Declining Balance Method Formula
Under the Declining Balance Method Formula, the depreciation is computed as:
Declining Balance Method Example
Let’s understand the same with the help of examples:
Ram purchased a Machinery costing $11000 with a useful life of 10 years and residual value of $1000.The rate of Depreciation is 20%. Depreciation as per the DBM is computed as follows:
Thus the Machinery will be depreciated over the useful life of 10 years at the rate of depreciation (20% in this case). As we can observe the DBM result 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). Under the Double Declining Balance (DDB) method two times the straight-line rate is applied to the declining balance. It is an ideal depreciation method for assets that quickly lose their value or are subject to technological obsolescence. Under Double Declining Balance Method the depreciation is computed by the formula:
This is 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 is having no residual value, this method will never depreciate the asset fully and is typically changed to the Straight Line depreciation method at some stage during the asset’s life.
Let’s understand the same with the help of a declining balance method example:
ABC Limited purchased a Machine costing $12500 with a useful life of 5 years. The Machine is expected to have a salvage value 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 is having a residual value of $2500, depreciation expense is limited to $10000 ($12500-$2500) and as such the depreciation in year 4 will be limited to $200 ($10000-$9800) rather than $1080 as computed above and for Year 5 depreciation expense will be $0 as the assets are already fully depreciated.
- 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 Sheet.
- Due to higher depreciation in Initial years, Net Income is reduced which results in tax benefits due to lower tax outflow.
- It results in lower Net Income during the initial years of an asset as Depreciation is higher initially.
- It is not an ideal method for those assets which don’t lose their value quickly like Equipment and Machinery.
Differences Between Straight Line Method and Declining Balance Method
|Basis for comparison||Straight Line Method||Declining Balance Method|
|Meaning||Under this method, the cost of an asset is uniformly fixed divided into the number of years of useful life of an asset||Under this method, a constant rate is applied over the assets declining book value (Cost minus Accumulated Depreciation|
|Calculation of Depreciation||It is calculated on the original cost of the asset which is fixed throughout the life of the asset.||It is calculated on the book value of the asset which keeps on declining year after year (Cost-Accumulated Depreciation)|
|Amount of Depreciation||It is less compared to the Declining Balance Method||It is usually higher during the initial years and reduces every year.|
|Suitability||Straight Line Depreciation Method is ideal for those assets which require negligible maintenance expenses and are not prone to technological obsolescence||Declining Balance Method is appropriate for assets that require more repairs and maintenance expenses as they get older and also for those assets which are prone to technological obsolescence as it results in higher depreciation during the initial years of an asset’s life.|
Choosing the right method of depreciation to allocate the cost of an asset is an important decision that the management of a company has to undertake and companies need to opt for the right depreciation method keeping into consideration the asset in question, its intended use and the impact of technological changes on the asset and its utility. DBM has its own 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 benefits only which becomes evident in cases where companies make large gains on the sale of assets.
Declining Balance Method of Depreciation Video
This has been a guide to what is the Declining Balance Method of Depreciation. Here we discuss 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 –