What is a Declining Balance Method
The declining balance method, also known as the reducing balance method, is an accelerated depreciation method that records larger depreciation expenses during the earlier years of an asset’s useful life, and smaller ones in later years.
Declining Balance Method
BREAKING DOWN Declining Balance Method
The declining balance method is a good depreciation method for assets that quickly lose their value or become obsolete, like computer equipment and other technology that has more utility in the earlier years of their life, before technological advancements make it necessary to replace them. An accelerated method of depreciation will appropriately match how such assets are used, if they are phased out for newer assets in only a few years.
Under the generally accepted accounting principles (GAAP) – which is a form of accrual accounting – expenses are recorded in the same period as the revenue that is earned as a result of those expenses. So, long-lived assets are put on the balance sheet at cost, and then, using the matching principle, expensed (depreciated) against revenue over the useful lifetime of the asset.
For assets whose book value (the cost of an asset minus accumulated appreciation) is used up bit by bit, throughout their useful life, such as semi-trailer that helps generate revenue by transporting goods, the straight-line depreciation might be the most 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 purchases a truck for $15,000 with a salvage value of $5,000 and a useful life of five years, the annual straight-line depreciation expense is equal to $15,000 minus $5,000 divided by five, or 20% of $10,000.
Calculating Depreciation Using Declining Balance Method
Depreciation under declining balance method is calculated as follows:
Depreciation per annum = (Net Book Value - Residual Value) x %Depreciation Rate
Net book value is the asset's net value at the start of an accounting period, calculated by deducting the accumulated (total) depreciation from the cost of the fixed asset. Residual value is the estimated salvage value at the end of the useful life of the asset. And the rate of depreciation is defined according to the estimated pattern of an asset's use over its useful life.
For example, if an asset that costs $1,000 and has a salvage value of $100 after ten years is depreciated at 30% each year, the expense is $270 in the first year, $189 in the second year, $132 in the third year, and so on.
Questioning the Assumptions Underlying a Company's Choice of Depreciation Method
Investors should look carefully at the footnotes in the financial statements, where the assumptions underlying the choice of depreciation method are sometimes discussed. Assumptions regarding the useful life of an asset, salvage value and the rate of depreciation can have a big impact on the bottom line. Changing the expected life of an asset or rate of depreciation can flatter reported income and the balance sheet, by reducing depreciation expenses and the rate at which the book value of assets decline. Similarly, overestimating salvage value, can make earnings look better than they really are.
If a company often recognizes large gains on sales of assets, it might be a sign that the company is using accelerated depreciation methods, like the double-declining balance depreciation method. Net income will be lower for a number years, but because book value ends up being lower than market value, there is a bigger gain when the asset is sold. If this asset is still a valuable one, its sale could give a misleading picture of the company's underlying health. However, public companies tend to shy away from accelerated depreciation methods — even though accelerated depreciation results in a deferment of taxation liabilities — as net income is reduced in the short-term.