Definition
The Declining Balance Method of Depreciation is a method used to recognize the majority of an asset’s depreciation earlier in its life. In this method, every accounting period, a fixed percentage of the book value of assets is deducted. Therefore, the depreciation cost is highest in the first period and reduces in subsequent periods.
Key Takeaways
- The Declining Balance Method of Depreciation is a form of accelerated depreciation where an asset loses its value more quickly earlier in its life. This can provide substantial tax benefits in short term.
- The calculation of depreciation using this method involves a fixed percentage of the net book value (original cost minus accumulated depreciation) at the beginning of each period. This means that the depreciation expense tends to decrease over time.
- The Declining Balance Method does not consider the salvage value in calculating depreciation. However, depreciation is halted when the book value equals the salvage value, ensuring that the asset does not depreciate below its salvage value.
Importance
The Declining Balance Method of Depreciation is important in financial management as it is a type of accelerated depreciation method in which the value of an asset decreases at a faster rate earlier in its life.
This can be useful for assets like computer equipment or vehicles that lose most of their initial value within the first few years of use.
By applying this method, companies can achieve a more accurate representation of an asset’s actual economic value over its lifespan.
This not only provides companies a better financial picture, but also allows for significant tax benefits, as higher depreciation expenses in the earlier years of an asset’s life can help reduce taxable income.
Explanation
The Declining Balance Method of Depreciation is primarily used as a way to recognize the majority of depreciation costs earlier in the life cycle of an asset. This methodology reflects the reality that most assets are more useful and productive when they are new, and over time, as the asset ages, it becomes less productive, requires more maintenance, and its value diminishes significantly.
Therefore, under this method, a higher amount of depreciation is recorded in the first few years after an asset is purchased and then decreases over time. This method serves a pivotal role in businesses where assets, such as machinery and equipment, lose their value relatively quickly.
Adopting the declining balance method for such assets can provide a more accurate representation of their reducing value and their consumption patterns. Furthermore, the method helps companies to manage their net income prudently by marking higher depreciation in the initial years which can be beneficial in reducing taxable income.
This can lead to significant tax savings, thus improving the company’s cash flow.
Examples of Declining Balance Method of Depreciation
Automobile Depreciation: When you purchase a new car, its value begins to depreciate as soon as it is driven off the lot. The depreciation is typically higher in the first couple of years and then slows down. This is a classic example of the declining balance method of depreciation.
Electronics and Gadgets: A new laptop or smartphone loses value rather quickly due its fast obsoleting technology. Thus, using the declining balance method of depreciation is useful here, because much of this drop in value happens in the first years after purchase.
Machinery and Equipment: Businesses that use heavy machinery and equipment often apply the declining balance method of depreciation. This is because the efficiency and productivity of these assets usually decrease at a higher rate during the initial years of service, causing the assets value to depreciate faster at the start.
FAQs on Declining Balance Method of Depreciation
What is the Declining Balance Method of Depreciation?
The Declining Balance Method of Depreciation is a method of accelerated depreciation where an asset loses its value faster in its early years than in its later years. It’s calculated by taking the straight-line depreciation percentage and doubling it.
How is Declining Balance Method different from Straight Line Method?
The main difference between the declining balance method and the straight line method is the time it takes to depreciate the asset. With the declining balance method, the majority of depreciation takes place in the early years of an asset’s life. The Straight-line method evenly spreads the depreciation over the course of the asset’s useful life.
When to use Declining Balance Method of Depreciation?
The Declining Balance Method is often used for assets that lose their value quickly. This could be due to rapid technological advancement or because the asset is subject to heavy use. This method assigns more depreciation in the early years of an asset’s life and less in the later years.
What are the benefits of using Declining Balance Method?
A significant benefit of the declining balance method is that it allows businesses to write off assets more swiftly, providing a quicker return on investment. This could also lead to substantial tax savings in the earlier years of asset ownership.
How to compute for Depreciation using the Declining Balance Method?
To compute depreciation using the declining balance method, you would need to know the asset’s initial cost, its expected useful life, and the chosen depreciation rate. The depreciation expense for the first year is calculated by applying the depreciation rate to the asset’s initial cost. For subsequent years, the depreciation expense is calculated by applying the depreciation rate to the asset’s carrying amount at the beginning of that year.
Related Entrepreneurship Terms
- Accelerated Depreciation
- Book Value
- Salvage Value
- Depreciable Life
- Net Book Value
Sources for More Information
- Investopedia: This website offers a vast library of financial and investment related resources, including an explainer on the Declining Balance Method of Depreciation.
- Accounting Coach: Known for explaining topics in simple terms, this website includes lessons and explanations on various accounting methods, with specific resources on depreciation methods.
- Corporate Finance Institute: This site offers a range of resources intended for accounting and finance professionals. Their resources include guides on many financial topics, including depreciation methods.
- My Accounting Course: This website provides a comprehensive library of accounting lessons, quizzes, and courses, including resources on different methods of depreciation.
