What is depreciation?
Depreciation is included in operating expenses in the income statement, deducted from the non-current assets in order to report the net book value on the balance sheet, and added back in the cash flow statement in the operating activities section.
Non-current assets are assets that have a useful life of more than one year. It also includes property, plant and equipment.
Any purchase of property, plant or equipment is a huge investment and it would be unfair to deduct the entire amount in one accounting period.
Hence, according to IAS 16 the cost should be allocated throughout the useful life of the asset on a systematic basis.
This allocation of cost is called depreciation. One of the commonly known and used methods of depreciation is the double declining method.
Double declining method of depreciation:
This method of depreciation is an accelerated method of depreciation meaning it reduces the value of asset at a faster rate than the straight-line method of depreciation.
It is also known as reducing balance method. It depreciates in such a way that higher depreciation expenses are charged in the early years of the useful life of asset.
Double declining method or reducing balance method of depreciation is most appropriate for assets like plant and machinery.
In this era of technological advancement, assets like plant and machinery or equipment lose its value rapidly due to introduction of better devices every now and then.
The formula to calculate annual depreciation with double declining method is:
(Net Book Value – Scrap Value) * Depreciation Rate
Where, Net book Value of an asset is its carrying amount less accumulated depreciation; Scrap Value is the amount that you expect to receive at the disposal of asset at the end of its useful life.
ARTT Ltd. is a manufacturing company that acquired a plant costing $750,000 on 1st January 2019. It expects to dispose of the plant as scrap for $5,000 at the end of its useful life.
ARTT ltd depreciates its assets at 20% using the double declining method. Calculate the annual depreciation expense of ARTT ltd for the next 3 years.
|Year||Net Book Value||Working||Annual depreciation||Accumulated Depreciation|
|2019||750,000||(750,000-5,000) x 20%||149,000||149,000|
|2020||601,000||(601,000-5,000) x 20%||119,200||268,200|
|2021||332,800||(332,800-5,000) x 20%||65,560||333,760|
As shown in the table, the annual depreciation expense kept on decreasing and the highest depreciation charge was in the year the plant was acquired.
If we compare this to the straight-line method, the annual depreciation would be $150,000 (750,000 x 20%) in all the years i.e. 2019, 2020 and 2021.
Entities usually opt for this method to decrease the income tax amount they will have to pay since depreciation is a deduction allowed.
Also, this method correctly assumes that the plant would rapidly lose its value in the market since it is a technological equipment.
Other than that, the plant also works best at the start of its useful life since it has the maximum capacity.
With time, due to wear and tear and usage, the plant’s capacity reduces leading to lower output production.