Reducing Balance Method is appropriate where an asset has a higher utility in the earlier years of its life. Computer equipment also becomes obsolete in a span of few years due to technological developments. Using reducing balance method to depreciate computer equipment would ensure that higher depreciation is charged in the earlier years of its operation.
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Declining Depreciation vs. the Double-Declining Method
Net book value is the carrying value of fixed assets after deducting the depreciated amount (or accumulated depreciation). It is the remaining book value of the fixed asset after it is used for a period of time. The net book value is calculated by deducting the accumulated depreciation from the cost of the fixed asset. Assets that face a relatively high risk of technological obsolescence progressively decrease the competitive advantage a company can gain from their use. The depreciation method used should therefore charge a higher portion of the cost of such assets in the earlier years which is why reducing balance method is most appropriate. As an alternative to systematic allocation schemes, several declining balance methods for calculating depreciation expenses have been developed.
Declining Balance Method of Assets Depreciation
- Under the declining balance method, yearly depreciation is calculated by applying a fixed percentage rate to an asset’s remaining book value at the beginning of each year.
- The double-declining method involves depreciating an asset more heavily in the early years of its useful life.
- With declining balance methods of depreciation, when the asset has a salvage value, the ending Net Book Value should be the salvage value.
- 150% declining balance depreciation is calculated in the same manner as is double-declining-balance depreciation, except that the rate is 150% of the straight-line rate.
Accruing tax liabilities in accounting involves recognizing and recording taxes that a company owes but has not yet paid. Because the book value declines as the asset ages and the rate stays constant, the depreciation charge falls each year. As a hypothetical example, suppose a business purchased a $30,000 delivery truck, which was expected to last for 10 years. Under the straight-line depreciation method, the company would deduct $2,700 per year for 10 years–that is, $30,000 minus $3,000, divided by 10. Referring to Example 1, calculate the depreciation of the asset for the second year of its life. Depreciation is charged according to the above method if book value is less than the salvage value of the asset.
As you can see from the above example, depreciation expense under reducing balance method progressively declines over the asset’s useful life. A more common depreciation method is the unemployment straight-line method, where the depreciation expense to be recognized is spread evenly over the useful life of the underlying asset. This method is the simplest to calculate, and generally represents the actual usage of assets over time. It is also more likely to leave carrying values on the balance sheet that reflect the remaining market values of assets (though there is not necessarily a direct relationship between carrying value and market value). The company ABC has the policy to depreciate the machine type of fixed asset using the declining balance depreciation with the rate of 40% per year. The machine is expected to have a $1,000 salvage value at the end of its useful life.
This is usually when the net book value of the fixed asset is below the minimum value that asset is required to be capitalized (which should be stated in the fixed asset management policy of the company). As under reducing balance method assets are depreciated at a faster rate in the early stage of their useful life, it is a more suitable method for assets that have greater utility in the earlier years. A better method for depreciating assets whose utility progressively increases is the Sum of the Digits Method. 150% declining balance depreciation is calculated in the same manner as is double-declining-balance depreciation, except that the rate is 150% of the straight-line rate.
However, the company needs to use the salvage value in order to limit the total depreciation the company charges to the income statements. In other words, the depreciation in the declining balance method will stop when the net book value of the fixed asset equals the salvage value. Depreciation rate in the formula of declining balance depreciation above is the rate that the management of the company decides on each type of fixed asset based on their past experiences and how the assets are being used. Also, this yearly rate of depreciation is usually in line with the industry average. The company can calculate declining balance depreciation for fixed assets with the formula of the net book value of fixed assets multiplying with the depreciation rate. In general, the company should allocate the cost of fixed assets based on the benefits that the company receives from them.
How Does Depreciation Affect Taxes?
Declining Balance Depreciation is an accelerated cost recovery (expensing) of an asset that expenses higher amounts at the start of an assets life and declining amounts as the class life passes. The amount used to determine the speed of the cost recovery is based on a percentage. The most common declining balance percentages are 150% (150% declining balance) and 200% (double declining balance). Because most accounting textbooks use double declining balance as a depreciation method, we’ll use that for our sample asset. The declining balance method of Depreciation is also called the reducing balance method, where assets are depreciated at a higher rate in the initial years than in the subsequent years.
Because twice the straight-line rate is generally used, this method is often referred to as double-declining balance depreciation. DDB is ideal for assets that very rapidly lose their values or quickly become obsolete. This may be true with certain computer equipment, mobile devices, and other high-tech items, which are generally useful earlier on but become less so as newer models are brought to market. Under the generally accepted accounting principles (GAAP) for public companies, expenses are recorded in the same period as the revenue that is earned as a result of those expenses.
Thus, when a company purchases an expensive asset that will be used for many years, it does not deduct the entire purchase price as a business expense in the year of purchase but instead deducts the price over several years. It 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 has 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. Thus, the Machinery will depreciate over the useful life of 10 years at the rate of depreciation (20% in this case). As we can observe, the DBM results in higher depreciation during the initial years of an asset’s life and keeps reducing as the asset gets older.
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Also, note that the expense in the fourth year is limited to the amount needed to reduce the book value to the $20,000 salvage value. In the second year, depreciation is calculated in a regular way by multiplying the remaining book value of $36,000 ($40,000 — $4,000) by 40%. The arbitrary rates used under the tax regulations often result in assigning depreciation to more or fewer years than the service life. They determine the annual charge by multiplying a percentage rate by the book value of the asset (not the depreciable basis) at the beginning of the year. It must be applied where an asset is expected to face technological obsolescence relatively quickly.
The following examples show the application of the double and 150% declining balance methods to calculate asset depreciation. Under the declining balance method, yearly depreciation is calculated by applying a fixed percentage rate to an asset’s remaining book value at the beginning of each year. For example, if the fixed asset management policy sets that only long-term asset that has value more than or equal to $500 should be recorded as a fixed asset. Those that have value less than $500 should be recorded as expenses immediately. In this case, when the net book value is less than $500, the company usually charges all remaining net book balance into depreciation expense directly when it uses the declining balance depreciation.