Declining Balance Depreciation

What is the Declining Depreciation Method?

The declining balance depreciation method is used to calculate the annual depreciation expense of a fixed asset. Alternatively the method is sometimes referred to as the reducing balance method, or the diminishing balance method.

The depreciation expense is given by the declining balance method formula as follows:

Where:
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 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 declining balance method formula shown below is used to calculate the declining balance rate (DB Rate).

Suppose for example 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. 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 Method Example

Using the rate from the calculation above, the declining balance depreciation for each of the 4 years is as follows.

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 method, the net book value of an asset will never fall to zero

The diagram below shows the analysis by year of the declining method depreciation expense.

Summary

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.

In the above case, after 4 years, the amount of 8,704 will have been charged to the income statement as a depreciation expense. The other side of the depreciation expense is a credit entry to the accumulated depreciation account.

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 business would sell the asset for 1,296 and purchase a new asset utilizing the profit set aside by the depreciation expense.

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.