Declining Balance Method

Introduction

When it comes to managing finances, businesses and individuals alike need to have a clear understanding of various accounting methods. One such method that is commonly used is the declining balance method. This method allows for the systematic allocation of an asset's cost over its useful life. By using this method, businesses can accurately track the depreciation of their assets and make informed financial decisions. In this article, we will explore the declining balance method in detail, discussing its benefits, drawbacks, and how it is calculated.

What is the Declining Balance Method?

The declining balance method, also known as the reducing balance method, is an accounting technique used to calculate the depreciation of an asset. Depreciation refers to the decrease in value of an asset over time due to wear and tear, obsolescence, or other factors. This method is widely used because it allows businesses to allocate a higher depreciation expense in the early years of an asset's life and a lower expense in the later years.

Example:

Let's say a company purchases a delivery van for $50,000 with an estimated useful life of five years. Using the declining balance method, the company can choose a depreciation rate, such as 20%. In the first year, the depreciation expense would be $10,000 (20% of $50,000). In the second year, the depreciation expense would be $8,000 (20% of the remaining $40,000). This pattern continues until the asset's value is fully depreciated or until the company decides to stop using the asset.

Benefits of the Declining Balance Method

The declining balance method offers several advantages for businesses:

• Higher depreciation in early years: By allocating a higher depreciation expense in the early years, businesses can more accurately reflect the asset's actual wear and tear during that period. This can help in making informed decisions about asset replacement or repairs.
• Matching expenses with revenue: The declining balance method allows businesses to align their expenses with the revenue generated by the asset. This helps in determining the true profitability of the asset over its useful life.
• Tax benefits: In many countries, tax laws allow businesses to claim higher depreciation expenses in the early years. This can result in significant tax savings for businesses.

Drawbacks of the Declining Balance Method

While the declining balance method has its advantages, it also has some drawbacks that businesses should consider:

• Lower book value: As the declining balance method allocates higher depreciation expenses in the early years, the book value of the asset decreases rapidly. This can lead to an inaccurate representation of the asset's true value on the balance sheet.
• Complex calculations: Calculating depreciation using the declining balance method can be more complex compared to other methods. Businesses need to determine the appropriate depreciation rate and keep track of the asset's remaining value each year.
• Not suitable for all assets: The declining balance method may not be suitable for assets that do not experience higher wear and tear in the early years. For example, land or buildings may have a more consistent value over their useful life.

Calculating Depreciation using the Declining Balance Method

To calculate depreciation using the declining balance method, businesses need to follow these steps:

1. Determine the asset's initial cost and estimated useful life.
2. Select an appropriate depreciation rate. This rate is usually higher than the straight-line depreciation rate.
3. Calculate the depreciation expense for the first year by multiplying the depreciation rate by the asset's initial cost.
4. Subtract the depreciation expense from the asset's initial cost to get the asset's book value at the end of the first year.
5. Repeat steps 3 and 4 for each subsequent year until the asset is fully depreciated or until the business decides to stop using the asset.

Case Study:

Let's consider a case study to understand the declining balance method better. ABC Manufacturing Company purchases a machine for $100,000 with an estimated useful life of five years. The company decides to use a depreciation rate of 30%.

Year 1: Depreciation expense = 30% of $100,000 = $30,000

Book value at the end of Year 1 = $100,000 – $30,000 = $70,000

Year 2: Depreciation expense = 30% of $70,000 = $21,000

Book value at the end of Year 2 = $70,000 – $21,000 = $49,000

This pattern continues until the asset is fully depreciated or until the company decides to stop using the asset.

Conclusion

The declining balance method is a valuable tool for businesses to accurately track the depreciation of their assets. By allocating higher depreciation expenses in the early years, businesses can better reflect the asset's actual wear and tear. This method also allows for better matching of expenses with revenue and can result in tax benefits for businesses. However, it is important to consider the drawbacks of this method, such as lower book value and complex calculations. Overall, the declining balance method is a powerful accounting technique that can help businesses make informed financial decisions and manage their assets effectively.