In accounting, depreciation is the allocation of an asset’s cost over its useful life. In each accounting period, a business incurs depreciation expenses. The expenses account for the wear and tear that results from using an asset in its day-to-day activities such as a building. As an accountant, you may apply a couple of methods in financial reporting to depreciate an asset. Of the available methods, you should select the best method in order to reduce your expenses. One of the most reputable methods used to calculate depreciation of an asset is the declining balance method. You may also know it as the reducing-balance method.
You can calculate the declining balance method by depreciating a different amount of the asset every year as your balance reduces. It is unlike the straight-line method, which you calculate using the same depreciation rate each year. This article will give a detailed overview on what the declining balance method entails and how to use it appropriately.
What Is the Declining Balance Method?
The declining balance method is one of the most widespread methods to calculate a company’s depreciation expense. You can calculate it by applying the depreciation rate against the balance of an asset that did not depreciate. This method charges depreciation at a higher rate in the earlier years of an asset. Then, the amount declines as the life of the asset advances.
In accounting, the declining balance method helps to identify the expenses that your business incurs against the income that it generates. Compared to the straight-line method, this method works by doubling the depreciation rate of your assets.
Why Would You Use the Declining Balance Method?
Accountants can use the declining balance method in financial reporting in order to have an unvarying combination of the:
- Depreciation expense;
- Maintenance expense;
- Repairs during the lifetime of an asset.
This method assigns:
- More depreciation expenses during the initial years of an asset’s life;
- Less depreciation expenses in the asset’s later years.
This means that the declining balance method helps to match the asset value better. Moreover, it can be used in maximizing tax deductions and offsetting maintenance costs.
How to Calculate Depreciation with the Declining Balance Method
The declining balance method is a depreciation method that sees you incur more depreciation expenses in the early life of an asset and less in its later life. Instead of leaving the calculation of depreciation to a professional or using a software, here is a formula that you can use to calculate your declining balance depreciation.
- The first step is to calculate a straight-line depreciation rate, which is calculated using the formula: Straight-line depreciation rate = 1/useful life of the asset.
- The second step involves calculating the accelerated depreciation rate, which uses the following formula: Accelerated depreciation rate = straight line depreciation rate × specific percentage.
- After the above variables have been calculated, you may proceed to calculate the depreciation expense. This appears by using the following formula: Depreciation expense = Remaining book value × accelerated depreciation rate.
Below is an example that illustrates the formula:
Assuming that Softel Company has the following:
- Cost of asset: $500,000;
- Salvage value: $50,000;
- Useful life: 5 years;
- Step 1: 1/5 = 0.2 or 20%;
- 2: 20 × 2 = 40%;
3: 1st year’s depreciation is 500,000 x 40% = 200,000/ 2nd year’s depreciation is 300,000 x 40% = 120,000/ 3rd year’s depreciation is 180,000 x 40% = 72,000/ 4th year depreciation is 108, 000 x 40% = 43,200/ 5th year depreciation is 64,800 -50,000 = *14,800.
An asset cannot depreciate below its salvage value using the declining balance method. Since the depreciation of the 5th year is 64,800 x 40% = 25,920, and (64,800-25,920 = 38,880), it appears below the salvage value. This means it will be calculated as book value at the beginning of the year – salvage value.
How Can You Reduce the Depreciation Expenses?
You can use depreciation to allocate the cost of an asset over its useful lifetime. In order to increase your revenue, you may consider the following ways to help lower your business’s depreciation expense.
1. Increase the salvage value: The salvage value is the amount an organization believes it can sell an asset at the end of its useful lifetime. In the declining balance method above, you can see that the assets are don’t depreciate below their salvage value. Therefore, if you increase an asset’s salvage value, you will minimize the amount that can depreciate on your asset.
2. Change the depreciation method: Besides the declining balance method, there are also several other methods that you can use to calculate depreciation of assets. Choosing a friendlier depreciation method may lead to minimal depreciation expenses. Such include the straight-line depreciation method. This method estimates the depreciation expense by evenly spreading its rate over an asset’s useful life. On the other hand, the declining balance method doubles the depreciation rates. This one results to higher depreciation expenses.
3. Review the asset’s lifetime: In accounting, some assets depreciate according to their useful life estimation and not according to the activity you use the assets for. It is possible for you to lower your business’s assets depreciation expense if the estimates restate to allow your business to extend its asset’s useful life over an bigger period than the one that had been stated before. If the circumstances allow you to increase the lifetime of your assets from 3 years to 6 years, the assets will fetch a lower annual depreciation expense. This is because they have a longer period for depreciation.
To Sum It Up
The declining balance method is one of the most popular methods to calculate a company’s depreciation expense. In order to calculate it, you must have the cost basis of the asset, the useful life of the asset, and the book value of the asset at the beginning of the year.
If you need to obtain your depreciation expense, you need to apply the formula: Remaining book value × accelerated depreciation rate respectively.
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