Declining Balance Method of Depreciation

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What is the Declining Balance Method?

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. Under this method, a constant depreciation rate is applied to an asset's (declining) book value each year. This method results in accelerated depreciation and higher depreciation values in the early years of the life of an asset.

What is the Declining Balance Method?

Declining Balance Method Formula

Under the Declining Balance Method Formula, the depreciation is computed as:

Declining Balance Method = (Net Book Value - Residual Value) * Rate of Depreciation (in %)

Declining Balance Method of Depreciation in Video

Declining Balance Method Example

Let’s understand the same with the help of examples:

Example #1

Ram purchased a Machinery costing $11000 with a useful life of 10 years and a residual value of $1000. The rate of Depreciation is 20%. Depreciation as per the DBM is computed as follows:

Year	Depreciation	Depreciation	Value at the end of the year
1	20% ($11000-$1000)	$2,000	$8,000
2	20% ($8000)	$1,600	$6,400
3	20% ($6400)	$1,280	$5,120
4	20% ($5120)	$1,024	$4,096

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.

Among the most common DBM is Double Declining Balance (DDB). The straight-line rate is applied to the declining balance under the Double Declining Balance (DDB) method two times. It is an ideal depreciation method for assets that quickly lose value or are subject to technological obsolescence. Under Double Declining Balance Method the depreciation is computed by the formula:

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.

Let’s understand the same with the help of a declining balance method example:

Example #2

ABC Limited purchased a Machine costing $12500 with a useful life of 5 years. The Machine is expected to have a salvage value of $2500 at the end of its useful life.

Let’s calculate the depreciation using the Double Declining Balance method.

Year	Depreciation	Accumulated Depreciation
1	(2/5)*$12500=$5000	$5,000
2	(2/5)*($12500-$5000) = $3000	$8,000
3	(2/5)*($12500-$8000) = $1800	$9,800
4	(2/5)*($12500-$9800) = $1080	$10,880

From year 1 to 3, ABC Limited has recognized accumulated depreciation of $9800.Since the Machinery has a residual value of $2500, depreciation expense is limited to $10000 ($12500-$2500). As such, the depreciation in year four will be $200 ($10000-$9800) rather than $1080, as computed above. Also, for Year 5, depreciation expense will be $0 as the assets are already fully depreciated.

Advantages

It results in accelerated depreciation and is a good method to record depreciation of assets that quickly lose their value or become obsolete, like computer equipment and other technology products, thereby depicting fair market value on the Balance Sheet.
Due to higher depreciation in the Initial years, Net Income is reduced, which results in tax benefits due to lower tax outflow.

Disadvantages

It results in lower Net Income during the initial years of an asset as Depreciation is higher initially.
It is not ideal for assets that don't lose their value quickly, like Equipment and Machinery.

Differences Between Straight Line Method and Declining Balance Method

Basis for comparison	Straight Line Method	Declining Balance Method
Meaning	Under this method, the cost of an asset is uniformly fixed and divided into the number of years of the useful life of the asset.	Under this method, a constant rate applies over the assets declining book value (Cost minus Accumulated Depreciation.
Calculation of Depreciation	It is calculated on the asset's original cost, which is fixed throughout the asset's life.	It is calculated on the book value of the asset, which keeps on declining year after year (Cost-Accumulated Depreciation)
Amount of Depreciation	It is less compared to the Declining Balance Method.	It is usually higher during the initial years and reduces every year.
Suitability	The straight Line Depreciation Method is ideal for those assets which require negligible maintenance expenses and are not prone to technological obsolescence.	The Declining Balance Method is appropriate for assets that require more repairs and maintenance expenses as they get older and for those prone to technological obsolescence as it results in higher depreciation during the initial years of an asset's life.

Conclusion

Choosing the right method of depreciation to allocate the cost of an asset is an important decision that a company's management has to undertake. Companies need to opt for the right depreciation method, considering the asset in question, its intended use, and the impact of technological changes on the asset and its utility. DBM has pros and cons and is an ideal method for assets where technological obsolescence is very high. However, it is important from an Investor perspective to ensure that such an accelerated depreciation method is not deployed with the intent to suppress the Income of the business (due to high depreciation) and obtain tax benefits only, which becomes evident in cases where companies make large gains on the sale of assets.