What is the Declining Depreciation Method?
The declining balance depreciation method is used to calculate the annual depreciation expense of a fixed asset.
The declining balance method sometimes referred to as reducing balance, is a commonly used method of calculating the depreciation charge for an asset.
The depreciation charge is given by the declining balance depreciation formula as follows:
Rate is the fixed percentage rate.
Net Book Value is the original cost less accumulated depreciation to date on the asset.
Since the net book value is declining each year, the depreciation charge will decline each year.
The method is used as it evens out the total cost of an asset to the business. The cost of an asset normally comprises depreciation and repairs and maintenance. Using the declining balance method, the depreciation declines over time, but as the asset gets older, the repairs and maintenance increase over time, so the total cost tends to remain constant over the life of the asset.
Calculation of the Declining Balance Depreciation Rate
The formula for calculating the declining balance depreciation rate is shown below.
So for example, if a business has purchased equipment with a value of 10,000 and expects it to have a useful life of 4 years and an estimated salvage value of 1,296, then the declining balance depreciation rate calculation using the formula above would be as follows:
Rate = 1 - Years√(Salvage value / Cost) Rate = 1 - 4√(1,296 / 10,000) = 40%
In this example, the rate is a round number 40%, 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.
The rate would normally be 2 – 3 times the straight line depreciation rate.
Declining Balance Depreciation Example
Using the rate calculated above, the declining balance depreciation for each of the 4 years would be calculated as follows
|1||10,000||4,000||6,000||40% of 10,000|
|2||6,000||2,400||3,600||40% of 6,000|
|3||3,600||1,440||2,160||40% of 3,600|
|4||2,160||864||1,296||40% of 2,160|
Each year the declining balance depreciation rate is applied to the opening net book value of the asset. At the end of 4 years the net book value is 1,296 which equals the salvage value of the asset.
Using the declining balance depreciation method, the net book value of an asset will never fall to zero
The analysis of the declining balance depreciation is shown below:
The true purpose of calculating a depreciation expense is to allow the business to set aside money from its profits in order to be able to replace the fixed asset at the end of its useful life.
In the above case, after 4 years, 8,704 will have been charged to the income statement as a depreciation expense and placed in the accumulated depreciation account to remind the business that the funds will be needed to purchase new equipment in 4 years time.
At the end of the 4 years, the book value of the equipment would be 10,000 – 8,704 = 1,296, which is the salvage value of the asset. In theory, the asset would be sold for 1,296 and a new asset purchased utilizing the profit set aside by the depreciation charge.
It is important to understand that although the charging of depreciation affects the net income (and therefore the amount attributable to shareholders) of a business, it does not involve the movement of cash. No actual cash is put aside, the accumulated depreciation account simply reflects that funds will be needed in the future to replace the fixed assets which are reducing in value due to wear and tear.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.