Declining balance method is one of the popular technique to calculate depreciation charge that decreases with every successive period. As this is an accelerated depreciation method higher cost of asset will be allocated to expense in earlier periods of useful life and lower charge to the later ones. As the name suggests, decreasing depreciation charge is achieved by applying a constant percentage (called depreciation rate) on declining net book value of the asset. This method has several names including reducing balance method, deteriorating value method etc.
In reality, assets’ efficiency to generate cashflows is higher in the beginning of useful life and also require lesser repairs. To match the higher rate of benefits from the asset, higher depreciation charge should be recorded in earlier periods of useful life. As the asset ages, due to wear and tear, asset loses its potential and the rate of benefits its renders slows down. Break-downs, seizure, inconsistent performance all adds up to gradually decreasing cashflows over the period. Therefore, depreciation charge has to gradually decrease as well from one period to next.
Declining balance method calculates the depreciation on the basis of asset’s net book value. Meaning accountants first determine asset’s carrying amount for the period which is calculated by deducting accumulated depreciation from the cost of the asset.
Net Book value for the period = Cost of asset – Accumulated Depreciation
Accumulated depreciation is simply the total depreciation charge in prior periods. For example, if we are calculate depreciation for the third year then sum of depreciation for the first two years will make up accumulated depreciation to give third year’s net book value.
Once the net book value (also called carrying amount) is determined, a specific rate is multiplied to this value to find the depreciation for specific period.
Depreciation for the period = Net book value for the period x Depreciation Rate
One important thing to note is that asset’s residual value is not considered while calculating depreciation under declining balance method. A constant rate is multiplied straight to net book value which is decreasing every consecutive period as a result of depreciation charge. Entity will continue to calculate depreciation until the net book value is fairly equal to scrap value of asset. Entity will cease depreciating the asset further unless the scrap value of asset falls below than originally expected.
Example: Declining balance depreciation method
BnW frames bought a printing machine for $250,000. It is expected that machine has a residual value of $30,000. Entity uses declining balance method of depreciation and depreciates at 20% every year.
Give a schedule showing depreciation of asset for 5 years with workings.
One of the ways to calculate depreciation under declining balance method is to deduct accumulated depreciation from cost every year which is normally the case as financial statements are carried at historical cost basis.
However, instead of recalculating NBV every time we can simply carryforward the NBV of the previous year and ignore what the actual cost of asset was and the year accumulated depreciation balanace. In this case schedule will be slightly different as follows:
Although we get the same answer, but this approach is not recommended as users need information regarding cost of the asset and accumulated depreciation as well.