When a company owns the assets, they will remain useful for a certain period of life. Not only the accounting and financial reporting standards demand depreciating your assets and converting them into expenses. But it is also a requirement of the IRS to depreciate your assets over the estimated useful life.
There are several methods of depreciation used by varying industries and business entities. However, most companies use accelerated depreciation methods for recording depreciation expenses in every financial period. We’ve already covered how depreciation works and the accumulated depreciation concept. Now, we will find how to calculate depreciation expenses using the double-declining method.
Before jumping into the concept itself, we will recall some concepts of depreciation to refresh memory. This blog will help you calculate depreciation using the double-declining method, examples, and why the double-declining method is beneficial for business entities.
What Is Depreciation?
Depreciation can be defined as,
The periodic allocation of depreciable assets’ value into expense over the asset’s estimated useful life.
Depreciation has been defined under the International Accounting Standards(IAS 16) as,
The systematic allocation of the cost of a depreciable asset to expense over the asset’s useful life is called depreciation.
What do you need to know about depreciation?
- Depreciation is not a valuation method. There lies a misconception about depreciation that it is a valuation method. It is evident from the definition that it is an expense allocation method to meet the true and fair representation of financial information. The depreciation of the assets has no relation to the book value or market value. Book value or cost value of the assets is used for the calculation of depreciation.
- Depreciation is a non-cash expense. The income statement is not representative of cash flows. Instead, it represents the net increase or decrease in owner’s equity. The depreciation expense results in the decline of the owner’s equity and assets value.
- Consistent rules must be followed for depreciation calculation. Once a business entity has adopted a depreciation calculation method, it must remain consistent over the years. Although, it is encouraged to use different depreciation methods for different assets. However, there should be consistency in the methods.
- Residual Value And Useful Life: The estimated useful life is an important measure determining the cost written off for every accounting period. If the useful life is longer, you will write off a lower cost every year and vice versa.
Different Methods Of Calculating Depreciation
The most generally used methods of calculating depreciation are the straight-line method and declining balance method. The straight-line method considers the cost of the asset and divides it into equal payments over the estimated useful life. For instance, if the asset value is $1,000 and the residual value is $200. The useful life is 4 years. The annual depreciation will not change in all four years.
The declining balance methods are accelerated depreciation methods. Many businesses used accelerated methods instead of straight-line methods for depreciation calculation. In the accelerated method, the early years of an asset’s life are charged high, and smaller accounts are written off in later years.
Depreciation For Financial Reporting Vs. Depreciation For Tax Purposes
It is a norm that the depreciation methods used for financial reporting are different from those used for tax purposes. The depreciation done for financial statements is often called book depreciation. On the other hand, the depreciation for taxation is tax depreciation.
Book depreciation refers to the amount of depreciation expense recorded in the general ledger accounts of the companies. This is based on the matching principle of accounting, which says, the expenses related to certain revenues must be recorded in the same financial period.
Tax depreciation is calculated for recording for income tax return purposes. It is a general practice to use accelerated depreciation methods for tax purposes.
The basic difference between book and tax depreciation is the timing of calculations. The financial statements are prepared at the end of a financial period, and depreciation expense is calculated to deduct from the asset value. In contrast, the depreciation for tax purposes is calculated after the end of the financial period. Therefore, the time at which depreciation appears in the financial statement and tax return varies.
The accelerated method can be the declining balance method and the double-declining method. Let’s dive into the details of the double-declining method.
Double Declining Method Of Depreciation
The double-declining method of depreciation is the accelerated depreciation method. In this method, the depreciation rate charged in every financial period is twice what is charged in the straight-line method. The early year of an asset’s useful life have higher depreciation expense, and later years will be expensed lower.
In contrast, the depreciation expense remains the same for the whole life in the straight-line method.
How To Calculate Depreciation With Double-Declining Method
Let’s understand the calculation of depreciation expense under the double-declining method.
The depreciation rate in the double-declining method is calculated as follow:
Depreciation Rate = 2 X Basic Depreciation Rate
Depreciation Expense = Depreciation Rate X Book Value
Depreciation Expense = 2 X Depreciation Rate X Book Value
How is basic depreciation rate calculated?
The basic depreciation rate is a straight-line depreciation method rate charged to the assets. The base depreciation rate can be calculated as follow:
Basic Yearly write off = cost of the asset- residual value / Useful life
Basic Depreciation rate = 1/useful life X 100
Let’s try to comprehend the concept with the help of examples.
Example 1
Let’s say a company, Peter & CO., has equipment of value $30,000. The useful life of the equipment is 6 years, and the salvage value is $3,000. The company is required to calculate depreciation expenses by using the double-declining method.
Basic depreciation yearly write off = $30,000 – $3,000/ 6
Basic depreciation yearly write off= $4,500.
Basic Depreciation rate = 1/6 X 100 = 16.67%
Double-Declining depreciation rate = 2 X 16.67 = 33.34%
The depreciation schedule for equipment is given below.
Year | Computation | Depreciation Expense | Accumulated Depreciation | Book Value |
30000 | ||||
1 | 30,000 X 0.334 | 10,002 | 10,002 | 19,998 |
2 | 19,998 X 0.334 | 6,667.33 | 16,669 | 13,330.68 |
3 | 13,330.68 X 0.334 | 4,444.44 | 21,113.44 | 8886.68 |
4 | 8,886 X 0.334 | 2,962.81 | 24,076.25 | 5923.7409 |
5 | 5923.7509 X 0.334 | 1,974.975 | 26,051 | 3949 |
6 | 3949 – 949 | 949 | 27000 | 3000 |
Benefits Of Double-Declining Method
Here are some of the benefits of the double-declining method:
Matching Maintenance Costs
When the assets are used for business operation, the normal wear and tear are obvious. Therefore, the business management will incur maintenance costs to keep the machinery, equipment, and assets operational. The maintenance expense is recorded in the income statement and deducted from the profit.
It is also a general practice that the maintenance expenses are high in the later years. Therefore, the management will want to allocate less depreciation in the later years. If the double-declining method is possible, the beginning year will have a higher depreciation expense than in later years. Therefore, the maintenance cost gets offset.
Tax Obligations Can Be Reduced
The assets have higher efficiency in the early years of useful life. Therefore, if the management uses the straight-line method, fewer expenses will be allocated for high-revenue periods.
On the other hand, relatively higher expenses will be charged for later years. However, if we use the double-declining method, it distributes the expenses according to asset efficiency. The early years are charged higher expenses. As a result, the tax deduction will also be higher in the early years.
Asset Value Is Reflective Of Its Actual Worth
Another benefit of using the double-declining method also relates to the earlier discussed methods. As we talked about the maintenance costs, the value of assets in the market also declined. Although, the market value is not related to depreciation. But if the double-declining method is used, the asset’s book value will be better reflective of its market value. It is particularly true for technological products that become obsolete over time.
Limitations Of Double-Declining Method
Everything is not good about the double-declining method. There are some limitations of the method that are as follow:
- Unlike the straight-line method, all the accelerated depreciation methods are a little bit complicated. Similarly, the same goes for the double-declining method.
- There is a convention that business entities used the assets consistently over the useful life. Therefore, it is absurd to calculate the higher depreciation expenses in the early years. The opponents of the method say that the double-declining method is not reflective of the asset’s actual use.
- The profitability is also impacted by the method. The earlier years have lower profitability than the later years. So, when an asset is consistently used, operational profitability becomes doubtful under this method.
Conclusion
In this blog, we have tried to comprehend the topic of the double-declining method of depreciation. Since business entities extensively use this methodx purposes, it will help practitioners and the students understand the essence of the depreciation methods and their implications. We hope that calculating depreciation expenses for tax purposes is easy after reading and understanding this blog.