Double declining balance method is a widely used depreciation technique in accounting and finance. It allows businesses to allocate the cost of an asset over its useful life, providing a more accurate representation of its value as it declines with time. This method is especially beneficial for assets that experience rapid depreciation early on, such as technology or machinery.
To understand how the double declining balance method works, let’s take an example. Suppose a company purchases a machine for $50,000 with an estimated useful life of five years and no salvage value (i.e., the machine will have no residual value at the end). Using straight-line depreciation, we would allocate $10,000 per year ($50,000 divided by 5) towards the cost of the asset.
However, if we employ the double declining balance method instead, we start by assuming a higher depreciation rate than straight-line. In this case, let’s assume 40% (double 20%, as it suggests). In year one, we calculate 40% of $50,000 which equals $20,000. This amount is then subtracted from the initial cost to give us a new book value of $30,000 ($50,000 – $20,000).
In year two using this method again but with only four years remaining in our estimation period now), we calculate 40% of $30,000 which equals $12k so that our new book value becomes $18k ($30k – $12k). We continue this process until either reaching zero or when applying further deductions does not make sense due to anticipated salvage values.
One advantage of using this approach is that it accounts for accelerated depreciation during earlier stages in an asset’s life cycle when there might be substantial wear and tear or technological obsolescence. By allocating more significant amounts towards depreciation upfront—compared to straight line—the financial statements reflect these changes accurately.
Another benefit is that companies can recover the cost of an asset more quickly, which can be advantageous for tax purposes. By expensing a higher proportion of the asset’s value in earlier years, businesses can reduce taxable income and lower their tax liability.
However, it’s essential to note that while this method provides a more accurate reflection of an asset’s depreciation pattern over time, it may not always align with its actual physical condition. Some assets may depreciate differently than anticipated under this method due to factors such as regular maintenance or unexpected damage.
Furthermore, the double declining balance method is not suitable for all types of assets. It works best for items that experience rapid depreciation initially but then slow down over time. Using this technique on assets with a more consistent rate of decline might result in overstating depreciation expenses in later years.
In conclusion, the double declining balance method offers businesses a useful tool for accurately reflecting an asset’s decreasing value over time. By allocating larger portions towards depreciation upfront and gradually reducing those amounts as the years progress, financial statements provide a realistic representation of an asset’s worth throughout its lifespan. While there are advantages to using this approach, it is crucial to consider specific circumstances and consult accounting professionals when deciding on the appropriate depreciation method for your organization.