What is the declining balance method?
The declining balance method, also known as the declining balance method, is an accelerated depreciation method that records higher depreciation expenses in the first years of an asset’s useful life , and smaller in later years.
Decreasing balance method
How to calculate declining balance depreciation
Depreciation using the declining balance method is calculated as follows:
TheDecreasing amortization of the balance=VSBV×reRor:VSBV=current book valuereR=depreciation rate (%)TheThe
The current book value is the net asset value at the start of an accounting period, calculated by deducting the accumulated depreciation from the cost of the asset. The residual value is the estimated recovery value at the end of the useful life of the asset. And the depreciation rate is defined according to the estimated pattern of use of an asset over its lifetime.
For example, if an asset that costs $ 1,000 and has a salvage value of $ 100 and a life of 10 years is depreciated at 30% each year, the expense is $ 270 the first year, $ 189 the second year, $ 132 the third year, etc.
What does the declining balance method tell you?
The declining balance method is a good method of amortization for assets that quickly lose value or become obsolete, such as computer hardware and other technologies that are most useful in the first years of their lives, before technological advances make it necessary to replace them. An accelerated depreciation method will appropriately match the way these assets are used if they are phased out for newer assets in just a few years.
According to generally accepted accounting principles (GAAP) – which govern the financial reporting standards of public companies and require accrual accounting – expenses are recognized during the same period as the income generated by these expenses. Long-lived assets are recorded in the balance sheet at cost, then using the principle of matching expensed (amortized) against income over the useful life of the asset.
For assets whose book value (the cost of an asset minus the cumulative appreciation) is gradually used throughout their lifespan, such as a semi-trailer which contributes to generating income by transporting goods, linear depreciation may be the highest. appropriate method.
This method simply subtracts the salvage value from the cost of the asset, which is then divided by the useful life of the asset. So if a company buys a truck for $ 15,000 with a salvage value of $ 5,000 and a useful life of five years, the annual linear depreciation expense is $ 15,000 minus $ 5,000 divided by five, or 20 % of $ 10,000.
Assumptions underlying the chosen depreciation method
Investors should carefully review the footnotes to the financial statements, where the assumptions underlying the choice of depreciation method are sometimes discussed. Assumptions regarding the useful life of an asset, the salvage value and the depreciation rate can have a significant impact on net income.
Changing the expected life of an asset or the depreciation rate can flatter reported income and the balance sheet, reducing depreciation expense and the rate at which the carrying value of assets decreases. Likewise, an overestimation of salvage value can make income more attractive than it actually is.
The difference between declining balance and the double decrease method
If a business often recognizes significant gains in asset sales, this could be a sign that the business is using accelerated depreciation methods, such as the double declining balance depreciation method.
The net profit will be lower for several years, but since the book value ends up being lower than the market value, there is a greater gain when the asset is sold. If this asset is still valuable, its sale could give a misleading picture of the underlying health of the business. However, SOEs tend to avoid accelerated depreciation methods – even if accelerated depreciation results in deferred tax obligations – because net income is reduced in the short term.