Did you buy a computer or an equipment today? Wonder what if you had to sell it off in a year or two? How much would you get? No matter what you own, it won’t be of the same value tomorrow as it is today.
While it’s no secret that depreciation happens, when it comes to taxes, you might be better off selecting one method over the other when it comes to calculating the depreciation value. And that’s what this article will be allabout.
Before we start with the whole Double Declining Balance Methodthough, let’s look into what depreciation is all about. If you are new to the term,here is what you need to know;Depreciationis the reduction of a fixed asset’s registered cost using specificmethodsuntil the value of the asset falls extremelylow.
When we say ‘fixed assets,’we mean buildings, office equipment, furniture,machinery and more. However,althoughthelandis also an asset, we do not include it in the list because it is an asset thatcannotbe depreciated. The value of an asset such as landappreciatesovertimeunless there are other environmental reasons for devaluation.
Here is a video that talks about it in detail.
TYPES OF DEPRECIATION
To determinethe value of an asset, you have differenttypes of depreciationmethods and formulas. Few commonones are as below:
- Straight-Line Depreciation Method– This is considered one of the simplest methods of all. In thismethod,you will makethesimpleallocation of the depreciationrateevery year during the useful life of an asset.
Formula: Annual Depreciation Expense = (Cost of Asset/Remaining Value)/Useful life of the asset. - Unit of Production Method– This method is used to depreciate the asset based on the number of hours the assetisused, or the total production of units duringitsuseful life. You may saythatthe unit of production method calculates the output proficiency of the asset in question, instead of considering the number of years used.
Formula:Per Unit Depreciation = (Cost of Asset – Remaining Value)/Units produced duringits functioninglife - Double Declining Method– Double declining method is an accelerated depreciation method.In this method,companies take maximum depreciation charges in the initial years of useful life of the asset to lower profits in the income statements, instead of the later years when the asset loses its value. The lowering of profits in the initial yearsenables lower income taxes during that time.
Formula:Depreciation = 2 X Straight Line Depreciation % XBook Value*(beginning of the accounting period) - Sum of the Years’ Digits Depreciation Method– Quite close to the declining balance depreciation method, this method also results in accelerated depreciation during theuseful earlylife of an asset. For assets that can produce more in the initial years but slows down in the future,this methodis more usefulcompared to thestraight linedepreciation.
Formula:Depreciation for the Year = (Cost of Asset – Salvage Value) X Factor (every year)
*Book Value– An asset’s book value is its worth at a given point in time. It is equal to the asset’s cost basis, minus the accumulated depreciation amount.
The formula to evaluate an asset’s book value:BookValue = Asset’s cost basis – Accumulated depreciation
The benefit and reasonsforeach methodaredifferent, and using the right one that suits your business depends on the type of asset you have. While thestraight line depreciation method sounds the most convenient to use with streamlined accounting calculations, the decliningbalance method provides you a precise accounting of the asset’s value.
In a nutshell, depending on the nature of the assets and your company’s choice, you can pick one best-suiteddepreciation method.
PARTIAL YEAR DEPRECIATION
The purchase of an asset might not always happenatthe beginning of the accounting year. Sometimes, you might have to purchase some assets in the middle of a fiscal year as well,andthis complicates the calculation a bit.
However, depending on what accounting methods you apply, depreciation onthese sort of assetscan be treated differently. One of the methods would be partial year depreciation, in which the depreciation is evaluated exactly when the asset is in use and the convention in which the depreciation falls.
First,you will need to determine the asset’s depreciation. Checkif itwas usedfor the entire fiscal year. By using the asset’s existingdepreciation schedule, you can determine the depreciation of the asset.
Further, to extract the amount of the asset’s monthly depreciation, divide the total anticipated depreciation for the year by 12. Multiply this amount by thenumberofmonths of the fiscal that the assetwas owned. The result willprovide you with a total amount of depreciation forapartialyear.
Note: Each asset you purchase willbe depreciateddifferently. You will need to be mindful of which method you are using to depreciate an asset before you start your evaluation.
WHY SHOULD BUSINESSES RECORD DEPECIATION?
So,now that we know what depreciation is, and different kinds of methods of determining the value of assets are, here is why businesses should record depreciation.Understandingaccounting conceptswill help your business do more.
As explained above, the purpose of depreciation is to match the revenue generated by an asset for the business,with the cost of thefixed asset duringitsuseful life. Further, the cost of the asset is moved to the income statement from thebalance sheet during that time.
What if we don’t use depreciation in accounting?In suchcirc*mstances, we will be required to charge whatever assets we buy, immediately after.
The drawback of not using depreciation in accounting also leads toanoverstatementof assets and net incomein the balance sheet and income statement respectively.Other repercussions are thatthe costof the fixed assetisn’t consideredwhile setting the sales prices, and since the established priceswon’tbe high enough, the cost of the fixed asset may notbe coveredas a result.
WHAT IS A DOUBLE DECLINING BALANCE METHOD?
The double declining balance depreciation methodis usedfor accounting the expense of a long-term asset. This method is an enhanced form of depreciation thatis recognizedduring the initial few years of the fixed assets’ useful life. Some companies use this method to carry forward the taxes to future years, which is known as double declining balance depreciation.
This method also takes the depreciation charges in these initial years and lowers profits ontheincomestatement, instead of considering those later. Reason being, most of the assets loses its value after some time.
HOW DOES DOUBLE DECLINING DEPRECIATION WORK?
As per the GAAP (Generally Accepted Accounting Principles), public companies record expenses in the same period astherevenuegenerated from those expenses. For example, if a public company has bought an expensive asset and will be using it for several years, theentire asset expense is not deducted in the year ofitspurchase. The deductionis dividedinto many years.
Thisis beneficial for assets thatloseits value over a period, because though the depreciation expense of the asset might be larger initsinitial life,butit will become smaller later.
Forexample, let’s assume you buy a machine for $50,000. You’ll expect it to run fortenyears, and estimate a salvage value of $5,000. Under thestraight-linedepreciation method, your company will deduct $4,500 fortenyears ($50,000 – $5,000/10). With the double declining balance method, the deduction will be 20% of $50,000 ($10,000) in the first year, 20% of $40,000 ($8,000) in the second and so on.
HOW TO CALCULATE DEPRECIATION UNDER THE DOUBLE DECLINING METHOD?
Being anentrepreneurcomes with its risks.To be able to apply the double declining depreciation formula, you are required to know the asset’s useful life and price first.
By dividing 100% by the asset’s useful life (in no. years) you get the asset’sstraight-linedepreciation rate. Further, by multiplying that rate bytwo,you’ll get youdouble declining depreciation rate. With thismethod,you’ll see that the depreciation will continue untilthe asset’ssalvage value.
The salvagevalueof an asset is the resalevaluethat you can estimate by the end of the asset’s useful life.Tocalculate thecost of an asset that will depreciate, you can take the cost of the fixed asset and then minus the salvage value.
To summarize we may look at the below pointers:
- During the time of purchase of an asset, you’ll need to determine the original cost
- Determine the asset’s salvage value (the selling value of the asset onceit’suseful life is over)
- Determine the asset’s useful life
- Evaluate the asset’s depreciation rate (1/useful life)
- Tofind out the depreciation expense,and thenmultiplythebook value of the period by twice the depreciation rate
- Deduct this from the beginning value for the ending period value
- Repeat these steps to reach the salvage value
For example: If you have anasset that values $50,000, you’llestimate the salvage value to be around $5,000 in five years, by the time you are ready to sell it. That would mean, you will depreciate $45,000 over these many years. You will sell the asset for $5,000, and remove the asset from your accounting reports.
Here are two formulas to calculate straight line and double declining depreciation rates:
- Straight line depreciation rate = depreciation expense/depreciable base
- Double declining depreciation rate = straight line depreciation rate X 2
WHY WOULD A COMPANY USE DOUBLE-DECLINING DEPRECIATION ON ITS FINANCIAL STATEMENTS?
You need to take a look at theeconomics basicsto understand and answer the question.Using double declining balance depreciation on the financial statements allows aconstantblend of both depreciation expense and maintenance andrepairs expense, during the asset’s useful life.
During the useful life of an asset, the repairs and maintenance expenseisgenerally low therefore the depreciation expense is high. As time passes, the repairs and maintenance expense will rise, leading to lowered depreciation expense.
In suchcases,the companyreportslower net income during the useful life of the asset, which is pretty early and is mostly not deemed acceptable.
ADJUSTING DEPRECIATION CHARGES ON BALANCE SHEET, INCOME STATEMENT AND CASH FLOW STATEMENT
To understand how to adjust the depreciation charges on your balance sheet, income statement and cash flow statement, let us take an example of a machine that you purchased for a vital purpose in your company:
- If the cost of the machine is $50,000; the cash and equivalents will be reduced to that amount and willbe movedto property, plant and equipment section in the balance sheet.
- Right then, an outflow of the $50,000 will be visible in the cash flow statement as well.
- Now, $12,500 is going tobe chargedto the income statement as depreciation expense for the first year, $10,000 in the second and this will continue for 3 – 4 years more. Though you’ll have already paid for the machinery in full during the time of purchase, however, the expense will be distributed overtime.
- With every passing year, the depreciation expense will be added to property, plant and equipment section, to reduce anyvalueof the asset (this is also known as accumulated depreciation). As per the above example, after the first year, the accumulated depreciation will be $12,500, $10,000 in the second and so on.
- Once the machine’suseful life is over, the carrying value of the asset will be very less. You might as well sell the machine, and whether profit or loss, this salvage value of the machine will be hence recorded in the income statement. The amount received on selling the machine is the cash inflow in the cash flow statement, and this willbe registeredin the cash and equivalent section in the balance sheet
RECORDING DOUBLE DECLINING BALANCE DEPRECIATION FOR ACCOUNTING
Recording your depreciation every month will keep your financial statements updated. As and when youregisterthe depreciation of an asset, the depreciation expense and accumulated depreciation along withthenetvalue of your fixed assets will show in the profit & loss statement and your balance sheet respectively. You will be required to record these expenses in a journal entry.
To prove thatyou own the fixed assets, you’ll need to own enough documentation, like title documentation or contracts, purchase receipts, and others asproof.Along with that, to track each asset, you will also need to create adepreciation schedule.
You might need to focus onthis especially if the amount of depreciation you log in the accounting, varies from the onethatis loggedfor tax purpose.
What is a DepreciationSchedule?
A depreciation schedule breaks down a firm’slong-termasset’s depreciation.Thisis a calculation of the depreciation expense for the assets you purchased and then distributes the cost over the useful life of thoseassets.These schedules are not just for computing the expense but also to track the starting and endingaccumulated depreciation.
Thisscheduleallows a firm to track itslong-termassets and analyze the depreciation over time.You may conclude saying that it’s a description of the assets you purchase, it’s purchase date, cost, it’s useful life and its salvage value.
Also, the depreciation schedule provides information on the method of depreciation, the current year’s depreciation,accumulative depreciationfrom the purchase date till today and the net book value of the asset.
What is an Accumulated Depreciation?–Accumulateddepreciationisa fixed asset’s total depreciation, thatis chargedto expense from the time it was purchased andwas used. An accumulated depreciation account is a credit balance asset account; which means it will show on the balance sheet as a reduction from the fixed asset’s gross amount.
Theaccumulated depreciation amountincreases over time, as the depreciationis chargedagainst the fixed assets. The actual cost of the asset is the gross cost, whereas the actual cost of the asset minus the accumulated depreciation amount (and any damage) is the asset’s net cost (carrying amount).
When the asset is offitsuseful life, and you are planning to sell it, the accumulated depreciation amount is reversed, along with the actual cost of the asset.Thiseliminates all the record of the asset from the balance sheet of your company.
ADVANTAGES OF USING THE DOUBLE DECLINING BALANCE METHOD IN ACCOUNTING
We have constantlyreiterated on double declining balancemethodand also compared it to thestraight linedepreciation method. So, below areafewpoints,tosum up why it’s advantageous to use the double declining balance method in accounting.
- Double Declining Balance– This method uses the depreciation rate to double thestraight linedepreciation rate. Let us give you an exampleofthat. If thestraightlinedepreciation rate for a 5years asset is 10% each year, using the double declining balance method, the depreciation rateis doubledto 20%. Further, the distributed depreciation expenseis extractedby using the depreciation rate to multiply the depreciation base.
- Matching Asset Value– When you purchase an asset, you can rest assured that the asset will provide you with optimal usability, at least during the initial years.For example, any technically sophisticated device may go outdated as and whennew products launch. The devicemight not support the latest requirement,andthis could happen withinafewyears.Since the device waslatest during the time of purchase, itwill provideyouwithoptimal usage in the initial years.
- Depreciation expense is meant to be a fixed asset’s costdistributionso that the actual benefit of the asset’s usageis reflectedinthe same period.
- Maximizing Tax Deduction–As we keep mentioning,the initial years of an asset’s usage adds more value to acompanyand generatesbetter profits and revenue compared to later years.When this depreciation expenseis evenly distributed,it might not help a company whenitis usedfor tax deduction.In that case, companies need to apply the double declining balance method that gives higher depreciation expenses distributed in the initial years, to balance higher profits and revenues during the same period.
- Balancing Maintenance Costs– The value of every asset drops with passing years and will require plenty of quality maintenance to keep it up-and-running for a long time. These costs maybe deductedfrom the company’s profits. Inthese type of scenarios,companies opt to distribute minimal depreciation expenses for the later years, to avoid adding more cost deductions to reduce profits.
The double declining balance method distributes these depreciation expenses inadecliningmethod for the later years to balance the increased maintenance expenses,withtheleastdepreciation expenses in the same period.
Althoughdoubledeclining balanceisn’tusedfor tax purposes, a lot of companies apply this method for their internal accounting. Depreciation helps your accounts if you are planning on purchasing expensive assets.
Thismethodrepresents the value of electronics and cars precisely compared to other methods.It’s becausevehicles, devices, furniture andsomeother types ofmachinerylosevalue pretty quickly.
DISADVANTAGES OF USING THE DOUBLE DECLINING BALANCE METHOD IN ACCOUNTING
Now that we learned about the advantages, below areafewdisadvantages as well to consider before we move further. The double declining balancemethodalso has few drawbacks over the straight-line depreciation method:
- Compared to the simplestraight linedepreciation method,thedoubledeclining balance method is a little complicated.
- Sincethemajorityof your company’s assets will last more and will be used constantly during their useful life, depreciating the value atanacceleratedrate isn’t sensible. Also, it might not show the use of the assets precisely.
- Your company will not be as profitable later as in the early years. Therefore, it won’t be easy to gauge theoperatingprofit of the company.
ASSET ASSUMPTION
When we talk aboutthe term ‘depreciation,’it’sunderstood that it is a method that reduces a fixed asset’s registered cost until the value of the asset falls extremely low. If you purchaseda truck for delivery of your goods from one place to another,look at how you will be using the truck to sell the goods.
You canassumethe expense to chargeonboth the truck’s worth by the end ofitsuseful life and its lifetime. These assumptions will affect the book value of the asset as well as the net income, and will also influence the earning of the asset after selling (if you would), for profit or loss compared to thebookvalue.
60 Shares
