What it means
Depreciation spreads the cost of a long-lived asset over the years it is used, and the pattern of the spread should reflect the pattern in which the asset's economic benefits are consumed. Straight-line depreciation assumes the benefits are consumed evenly.
For many assets that is a reasonable simplification, but for some it is not: a new vehicle loses a large part of its value in its first year and less in each following year; a computer does most of its useful work before newer models make it obsolete; a machine produces more in its early years, before maintenance costs rise and downtime increases. The declining balance method matches these patterns by charging more depreciation early and less later.
The mechanism is a constant rate applied to a declining base. Each year's charge is the rate multiplied by the asset's book value at the start of the year (cost less accumulated depreciation), not by the original cost.
Because the base shrinks each year, the charge shrinks with it, in a geometric series. The rate is usually set as a multiple of the straight-line rate: double declining balance uses twice the straight-line rate (40% for a five-year asset, where straight-line would be 20%), and 150% declining balance uses one and a half times.
An alternative, less common in practice, calculates the exact rate that reduces cost to salvage value over the life. Two adjustments are needed to make the method work.
First, because a percentage of a declining balance never reaches zero, the asset would never be fully depreciated; in practice the depreciation stops when book value reaches the estimated salvage value, and the final year's charge is whatever brings it there. Second, in the later years the declining charge becomes smaller than the straight-line charge on the remaining balance would be, so many companies and tax systems switch to straight-line at that point, depreciating the remaining book value evenly over the remaining life.
Salvage value is not deducted from cost at the start, as it is under straight-line; it acts as a floor. The method's main practical significance is in tax.
Many tax systems allow or require accelerated depreciation for plant and equipment, and declining balance is the usual form. The total depreciation over the asset's life is the same as under straight-line, so the total tax deduction is the same, but it arrives sooner, which defers tax and improves cash flow in the early years: a real benefit worth the time value of the deferred tax.
Companies that use straight-line in their financial statements and declining balance for tax report a deferred tax liability for the difference, which builds in the early years and unwinds in the later ones. For financial reporting, the choice between methods is a judgement about the pattern of consumption of benefits, and it should be applied consistently.
Accelerated depreciation reduces reported profit in the early years of an asset's life and raises it later, which affects trends, ratios and any performance measures based on profit. A company investing heavily in new equipment under declining balance will show depressed profits while it invests and improved profits when it stops, an effect readers of the accounts should understand.
The method also produces lower book values in the early years, which affects return on assets and, for assets that are sold early, the gain or loss on disposal.
In practice
Real-world examples.
Example
A courier company depreciates its vans at 40% declining balance, reflecting the steep fall in resale value in the first two years, and finds that book values track the second-hand market closely.
Example
A software company depreciates servers at 50% declining balance over a four-year life, because most of their useful capacity is consumed before newer hardware makes them uneconomic to run.
Example
A manufacturer uses straight-line in its financial statements and 30% declining balance for tax, and reports a deferred tax liability that grows while it is expanding its plant and unwinds when investment slows.
Think of it
“Declining balance front-loads depreciation-bigger write-offs early that shrink each year.
Formula
Calculation
Depreciation charge for the year = Opening book value x Declining balance rate
Double declining balance rate = 2 / Useful life in years
Opening book value = Cost minus Accumulated depreciation to date
Floor: depreciation stops when book value reaches salvage value
Exact rate to reach salvage: Rate = 1 minus (Salvage value / Cost) to the power of (1 / Useful life)
Worked example. A machine costs $100,000, has a useful life of five years and an estimated salvage value of $10,000. Straight-line depreciation would be ($100,000 minus $10,000) / 5 = $18,000 a year. Double declining balance uses a rate of 2 / 5 = 40%.
- Year 1: $100,000 x 40% = $40,000; book value $60,000
- Year 2: $60,000 x 40% = $24,000; book value $36,000
- Year 3: $36,000 x 40% = $14,400; book value $21,600
- Year 4: $21,600 x 40% = $8,640; book value $12,960
- Year 5: $12,960 x 40% = $5,184, but that would take book value below the $10,000 salvage value, so the charge is $12,960 minus $10,000 = $2,960; book value $10,000
- Total depreciation = $40,000 + $24,000 + $14,400 + $8,640 + $2,960 = $90,000, the same total as straight-line, but $40,000 in year 1 against $18,000
Switch to straight-line test. At the start of year 4, the remaining depreciable amount is $21,600 minus $10,000 = $11,600 over two years, $5,800 a year, which is less than the declining balance charge of $8,640, so no switch is made. At the start of year 5 the remaining $2,960 over one year equals the floored charge.
Tax effect. At a 25% tax rate, the year 1 deduction under double declining balance is $22,000 higher than under straight-line ($40,000 minus $18,000), deferring $5,500 of tax. The deferral reverses over years 3 to 5, when the declining balance charge is lower.
Exact rate alternative. The rate that reduces $100,000 to $10,000 over five years is 1 minus (0.1) to the power of 0.2 = 1 minus 0.631 = 36.9%. Year 1 charge $36,900; year 5 closing book value $10,000 exactly, with no floor adjustment needed.Case study
Seen in the real world.
A delivery company bought a fleet of 50 vans for $30,000 each, $1,500,000 in total, with a five-year life and no expected salvage value. For its financial statements it chose straight-line depreciation of $300,000 a year, judging that the vans' usefulness to the business was roughly even over their life. For tax, the rules allowed double declining balance at 40%, and the finance manager took it.
The tax computation for year 1 deducted $600,000 against the $300,000 in the accounts, a difference of $300,000 that at a 25% tax rate deferred $75,000 of tax. In year 2 the tax deduction was 40% of the remaining $900,000, $360,000, against $300,000 in the accounts: a further $60,000 of difference and $15,000 of deferral, taking the cumulative deferred tax liability to $90,000.
In year 3 the tax deduction of $216,000 (40% of $540,000) fell below the accounting charge, and the difference began to reverse: $84,000 of reversal and $21,000 of tax caught up. The pattern continued until, by the end of year 5, both methods had deducted the full $1,500,000 and the deferred tax liability had returned to zero.
The company's board initially questioned the $90,000 liability on the balance sheet, asking why the company owed tax it had not been charged. The finance manager explained that it was tax the company had legitimately postponed, not avoided; it would be paid in years 3 to 5 as the accelerated deductions ran out. The benefit was the use of $90,000 for two to three years, worth about $7,000 at the company's borrowing rate, and the benefit would recur with every fleet renewal.
The board's other question was why the accounts did not simply use the same method as the tax computation, and the answer was that the accounts must show the pattern in which the vans were actually used, which was even, while the tax method was a policy choice by the tax authority to encourage investment. The two purposes are different, and the deferred tax entry is what reconciles them.
Watch out
Common mistakes.
- Applying the rate to the original cost each year rather than to the declining book value, which turns the method into straight-line at a higher rate and over-depreciates the asset.
- Deducting salvage value from cost before applying the rate, as under straight-line; under declining balance, salvage value is a floor, not a deduction from the base.
- Forgetting the floor, so that depreciation continues below salvage value, or forgetting that the asset is never fully depreciated without a final adjustment or a switch to straight-line.
Questions
People also ask.
What is the difference between declining balance and double declining balance?
Declining balance is the general method of applying a fixed rate to the remaining book value; double declining balance is the version in which the rate is twice the straight-line rate. Other multiples, such as 150%, are also used.
Why use declining balance rather than straight-line?
Because some assets deliver most of their benefit early and lose value quickly, and the accounts should reflect that; and because tax systems often allow it, which defers tax and improves early cash flow.
Does the method change the total depreciation?
No. Over the asset's full life, both methods depreciate cost less salvage value. The difference is timing: declining balance charges more early and less later.
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