REPORT ON THE DECLINING BALANCE METHOD OF DEPRECIATION

Contents
1.0 INTRODUCTION .................................................................................................................................. 2 1.1 TERMS OF REFERENCE ................................................................................................................. 2 1.2 PROCEDURE ..................................................................................................................................... 2 2.0 MAIN BODY.......................................................................................................................................... 2 2.1 DEPRECIATION ............................................................................................................................... 2 2.2 THE DECLINING BALANCE METHOD OF DEPRECIATION .................................................... 2 2.2.1 TERMINOLOGIES ..................................................................................................................... 3 2.2.2 The double declining balance method.......................................................................................... 3 2.2.3 The Single declining balance method .......................................................................................... 3 3.0 HOW THE DECLINING BALANCE METHOD OF DEPRECIATION IS APPLIED ........................ 3 3.1 Application procedure ......................................................................................................................... 4 4.0 PURPOSE OF THE DECLINING BALANCE METHOD OF DEPRECIATION................................ 4 5.0 CALCULATIONS .................................................................................................................................. 4 5.1 [Example 1], Double declining balance depreciation ......................................................................... 4 5.2 [Example 2] single declining balance method .................................................................................... 5 5.3 Advantages of the Declining balance method of depreciation............................................................ 6 5.4 Disadvantages of the Declining balance method of depreciation ....................................................... 6 6.0 CONCLUSION ....................................................................................................................................... 7 7.0 RECOMMENDATIONS ........................................................................................................................ 7 8.0 REFERENCES ....................................................................................................................................... 8

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REPORT ON THE DECLINING BALANCE METHOD OF DEPRECIATION

1.0 INTRODUCTION 1.1 TERMS OF REFERENCE On 9th November, 2011 at the request of Mr. Mfula our lecturer in building economics, we were assigned as members of groups 3 in our economics class to prepare a report on the Declining Balance method of depreciation. The report had to include the following areas of interest based on the topic in question: 1. 2. 3. 4. 5. What is declining balance method of depreciation? How is it applied? What is its purpose? Give two examples of the method and; Present Recommendations?

1.2 PROCEDURE The information contained in this report was collected through the following means: interviews and literature review. 2.0 MAIN BODY 2.1 DEPRECIATION Depreciation as defined by Bernstein L. A, (1990) is the reduction in value of an asset. He further added that the method used to depreciate an asset is a way to account for the decreasing value of the asset to the owner and to represent the diminishing value of the capital funds invested in it. The common methods of calculating depreciation include; Straight Line Method, Declining Balance Depreciation Method, Sum of Integers Depreciation and Sinking Fund Depreciation. 2.2 THE DECLINING BALANCE METHOD OF DEPRECIATION Declining balance depreciation method (or Reducing balance method or Diminishing balance method) is the accelerated method used in financial reporting to calculate depreciation provision annually. The method is unique in that it utilizes the book value of the asset (original cost accumulated depreciation) instead of the depreciation base (original cost salvage value). This method corresponds to the thought that as the productivity of the asset is at the pick in the starting years and decreases with the passage of time. Thus the depreciation expense for the starting years should be high and then reduces in line with the declining productivity. Declining balance method of depreciation has been classified into two types. These are; Double declining balance and Single Declining balance (Newnan and Lavelle, 1998). The formula for annual depreciation is as follows: Annual Depreciation = Book Value of Asset * Specified Depreciation Rate

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2.2.1 TERMINOLOGIES Book value represents the remaining, capital investment (not yet depreciated) on the books after the total amount of depreciation charges (to date) have been subtracted from the basis. The book value (BV) is usually determined at the end of each year. Market Value (MV) is the amount realized from sale on the open market. Salvage Value (S) is the estimated trade-in value or market value at the end the assets useful life. Depreciation Rate (dt) is the rate at which an asset loses its value. This can be weekly, monthly, annually etc. 2.2.2 The double declining balance method When using the double-declining-balance method, the salvage value is not considered in determining the annual depreciation, but the book value of the asset being depreciated is never brought below its salvage value, regardless of the method used. The process continues until the salvage value or the end of the asset's useful life, is reached. In the last year of depreciation a subtraction might be needed in order to prevent book value from falling below estimated Scrap Value. 2.2.3 The Single declining balance method Conversely, the Declining Balance method assumes a constant depreciation rate per year. And like the Sum-of-years method, more depreciation tends to occur earlier in the asset's life. Therefore, the single (fixed) declining balance method computes depreciation at a fixed rate. 3.0 HOW THE DECLINING BALANCE METHOD OF DEPRECIATION IS APPLIED It is applied in Microsoft Excels program in making tax accounting depreciation calculations for return preparation or tax planning purposes. Most income tax systems allow a tax deduction for recovery of the cost of assets used in a business or for the production of income. It allows for easy calculation of variable declining balance depreciation amounts including those based on Modified Accelerated Cost Recovery System MACRS (the only approved tax depreciation system in the United States) ( Stephen, 2008). It is applied in Economics to determine consumption of capital during production. In other words, wearing out of plant and capital goods, such as machines and equipment. It applies as a system is to allow a fixed percentage of the cost of depreciable assets to be deducted each year- capital allowances. Capital allowance calculations may be based on the total set of assets, on sets or pools by year (vintage pools) or pools by classes of assets (Baxter and William et al, 2000) Depreciation calculations can become complex if done for each asset a business owns. The declining balance method permits combining assets of a similar type acquired in the
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same year into a pool. Depreciation is then computed for all assets in the pool as a single calculation (Bernstein, 1989). 3.1 Application procedure When using double declining method schedule, the depreciation rate stays the same, the depreciation expense gets smaller each period, and the depreciable base gets smaller each period. Therefore, the Declining Balance (DB) (also known as fixed percentage or uniform percentage method) is applied as follows: Begin with the depreciable base, and calculate the depreciation expense for the period. Subtract that depreciation expense from the depreciable base to get the depreciable base for the next period. Report this process until you reach the salvage value. If the final depreciation expense would bring the asset value below salvage value, then simply subtract salvage value from the periods depreciable base to get the final depreciable expense.

4.0 PURPOSE OF THE DECLINING BALANCE METHOD OF DEPRECIATION It is frequently used for book depreciation purposes. It is used for discounting the value of equipment as it ages ( Kieso et al, 1995). 5.0 CALCULATIONS Note; in double declining depreciation method, the most common rate used is double the straight-line rate. Depreciation rate for double declining balance method = Straight line depreciation rate x 200% 5.1 [Example 1], Double declining balance depreciation On April 1, 2011, Company A purchased equipment at the cost of $140,000. This equipment is estimated to have 5 year useful life. At the end of the 5th year, the salvage value (residual value) will be $20,000. Company A recognizes depreciation to the nearest whole month. Calculate the depreciation expenses for 2011, 2012 and 2013 using double declining balance depreciation method. Useful life = 5 years Straight line depreciation rate = 1/5 = 20% per year Depreciation rate for double declining balance method is then doubled 20% x 200% = 40% per year or

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20% x 2 = 40% per year Depreciation for 2011 = $140,000 x 40% x 9/12 = $42,000 Depreciation for 2012 = ($140,000 - $42,000) x 40% x 12/12 = $39,200 Depreciation for 2013 = ($140,000 - $42,000 - $39,200) x 40% x 12/12 = $23,520 Double Declining Balance Depreciation Method Year 2011 2012 2013 2014 2015 Book Value at Depreciation the beginning Rate $140,000 40% $98,000 40% $58,800 40% $35,280 40% $21,168 40% Depreciation Expense $42,000 (*1) $39,200 (*2) $23,520 (*3) $14,112 (*4) $1,168 (*5) Book Value at the year-end $98,000 $58,800 $35,280 $21,168 $20,000

(*1) $140,000 x 40% x 9/12 = $42,000 (*2) $98,000 x 40% x 12/12 = $39,200 (*3) $58,800 x 40% x 12/12 = $23,520 (*4) $35,280 x 40% x 12/12 = $14,112 (*5) $21,168 x 40% x 12/12 = $8,467 Depreciation for 2015 is $1,168 to keep book value same as salvage value. $21,168 - $20,000 = $1,168 (At this point, depreciation stops.)

5.2 [Example 2] single declining balance method Assume the price of a depreciating asset is P and its salvage value after N years is S. You could assume the asset depreciates by a factor of (or a rate of %). This method is known as Single Declining Balance. In an equation this looks like:

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Annual Depreciation = Previous year's value So for our example, the depreciation during the first year is [$20,000/5] = $4,000 Below is an illustration of how the Declining Balance would depreciate the asset in 5 years with $20,000 book value. Year 1 2 3 4 5 Depreciation Year-end Value

[$20,000.00/5] = $4,000.00 $16,000.00 [$16,000.00/5] = $3,200.00 $12,800.00 [$12,800.00/5] = $2,560.00 $10,240.00 [$10,240.00/5] = $2,560.00 $8,192.00 [$12,800.00/5] = $2,560.00 $6,553.60

5.3 Advantages of the Declining balance method of depreciation The model accelerates depreciation compared to straight line. It gives a more realistic reflection of an asset's actual expected benefit from the use of the asset. Reducing balance method is easy to understand and simple to implement. Depreciation is calculated every year on the opening balance of asset. Reducing balance method equalizes the yearly burden on profit and loss account in respect of both depreciation and repairs. The amount of depreciation goes on decreasing while the expenses on repairs goes on increasing, so that the total charge against revenue over different years remains more or less the same. Reducing balance method is acceptable for income tax purposes Reducing balance method matches the cost and revenue of the business. The greater amount of depreciation provided in initial years is matched against the higher amount of revenue generated by increased production by the use of new asset (White et al 1994). 5.4 Disadvantages of the Declining balance method of depreciation It has an implied salvage that may be lower than the estimated salvage. Double-declining-balance depreciation does not always depreciate an asset fully by its end of life (Harrison et al, 1995). Reducing balance method charges heavy amount of depreciation in earlier years. The formula to obtain rate of depreciation can be applied only when there is residual value of the asset (Marullo et al, 1996).

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6.0 CONCLUSION Declining balance depreciation method (or Reducing balance method) is the accelerated method used in financial reporting to calculate depreciation provision annually. It computes depreciation at a fixed rate with a higher depreciation charge in the first year of an assets life and gradually decreasing charges in subsequent years. This arises from the fact that many assets are most useful when they are new. It is used in Economics to determine consumption of capital during production, in Microsoft Excels program in making tax accounting depreciation calculations for return preparation or tax planning purposes, and computing for assets in the pool as a single calculation. From the literature reviewed, the DB method is an acceptable system of calculating depreciation that is easy to use in modern society today. 7.0 RECOMMENDATIONS The method is easy to apply and can be used to calculate depreciation rates of various assets. This method of depreciation can be relied upon in order to determine realistic depreciation rates of assets. The method is suitable for both long term and short term decision making.

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8.0 REFERENCES 1. Baxter, William. "Depreciation and Interest." Accountancy. October 2000. 2. Bernstein, L.A. Financial Statement Analysis: Theory, Application and Interpretation. Irwin, 1989. 3. Cummings, Jack. "Depreciation Is Out of Favor, But It Matters." Triangle Business Journal. February 25, 2000. 4. Harrison, Jr., W.T., and C.T. Horngren. Financial Accounting. Prentice Hall, 1995. 5. Kieso, Donald E., and J.G. Weygandt. Financial Accounting. Wiley, 1995. 6. Marullo, Gloria Gibbs. "Catching Up on Depreciation." Nation's Business. October 1996. 7. Steven. L. Nelson, 2008 Using Microsoft Excels variable declining balance depreciation function Articles Factory. 8. White, G.I., A.C. Sondhi, and D. Fried. The Analysis and Use of Financial Statements. Wiley, 1994.

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