Depreciation can be described as the decrease in the value of your assets over the years. This concept is also known as fair value depreciation and affects the overall value of your business and the net income of your business is affected by the depreciation with respect to matching principle. Declining balance depreciation is the technique of accelerating the depreciation where the amount of depreciation that is charged on a particular asset reduces overtime. It means, a higher depreciation is charged during the initial years and lesser during the end. Remember that depreciating assets are intangible assets that you use to develop your business. These assets decline in their value over time because of obsolescence. You can take this course on the basics of business finance to understand this better.
You need to make a number of decisions to establish perfect depreciation schedules. Read on to find some basic strategies that will help you deal with depreciation with the most commonly used depreciation methods.
Declining Balance Depreciation
Declining balance depreciation is one of the widely used methods of computing depreciation in which the book value of a capital asset is reduced by a fixed percentage. This method results in larger depreciation amounts of an asset’s life in the early years and a decreased amount in the later part of its life. The difference amount is employed at the places where there is a uniform usage of an asset, regardless of its age. The residual value, also known as salvage value, is the value at which the assets can be sold after some years. Our course in financial accounting will help you better understand the different methods of depreciation.
Formula and Calculation
Depreciation = Depreciation Rate X Book Value of Asset
(Where, Depreciation Rate = Accelerator X Straight Line Depreciation Rate.)
In order to understand the formula, make sure you understand the below definitions.
Book Value – Book value is the actual difference between the value of an asset and its depreciation. During the initial years, the depreciation value is zero and hence, it is equal to the cost of the asset. The book value decreases gradually and the depreciation amount declines.
Accelerator – It is the multiplication factor that accelerates the depreciation. It is used to show the depreciation value at the end of first year and declines every consecutive year.
You can refer the below example to get a clearer picture of declining balance depreciation. If an asset that costs $2,000 is depreciated at 20% each year, the deduction is $400 in the first year and $320 in the second year, and so forth.
Higher Depreciation During Initial Years?
The reason why higher amounts of depreciation are charged during the initial years of an asset is because the assets are more productive during the early stage. Their productivity gradually decreases during the latter part of their lives. Therefore, during the initial years, the assets generate more revenue compared to the later years. According to the matching principle, to match the depreciation expenses with the revenue that is earned from the assets, you should depreciate more of the asset’s cost during the initial years. Our course on financial modelling will help you understand this better.
Double Declining Balance Depreciation Method
This is the most commonly used methods of depreciation, wherein large depreciation expenses are charged in the early years of the asset’s life. The double decline balance depreciation is also known as 200% declining balance method. It is considered as a common form of accelerated depreciation, where the asset will be depreciated at a faster rate than the straight line method. Though the depreciation is higher in this case, the total depreciation over the life of the asset is same as in the straight line method. This means, double declining balance depreciation will result in a much higher depreciation amount in early years and smaller in later years compared to the straight line method. The term ‘double’ in this method means 200% of the depreciation rate in straight line method.
Here is the formula to the Double Declining Balance Depreciation Method:
Depreciation Base * (2 * 100% / Useful Life of Asset in Years)
This method can be illustrated with an asset that is purchased on 1St January at a cost of $10,000 and is expected to have no salvage value for 10 years. Under straight line method, the annual depreciation of the asset will be 10% of the asset’s cost. Under double declining balance depreciation method, the annual depreciation of the asset will be 20% of the asset’s cost.
By understanding the principles of depreciation, you can surely establish a perfect accounting policy related to your business transactions. Learn more about budgeting and cash management in our course on cost accounting for small business owners. There is a broad array of depreciation methods available and the type of depreciation method you choose will have a strong impact on the bottom line of your business.