Double declining balance

What Is Double Declining Balance?

The double declining balance method is an accelerated depreciation method used in financial accounting to expense a tangible asset's cost more rapidly in its earlier years of useful life. This method records a higher depreciation expense in the initial periods and progressively lower expenses in later periods. It is often employed for tangible assets that lose more of their value or productivity in their early years, such as vehicles or certain types of machinery.

History and Origin

Depreciation accounting, in general, has evolved over time. While the concept of allocating the cost of an asset over its useful life has existed for centuries, the formalization of different methods, including accelerated depreciation techniques like the double declining balance method, gained prominence with the development of modern accounting standards. In the United States, significant shifts occurred with the evolution of Generally Accepted Accounting Principles (GAAP) and tax laws. For instance, in 1953, the U.S. Congress amended the Internal Revenue Code to permit companies to utilize accelerated historical cost depreciation for income tax purposes, leading many firms to adopt faster depreciation for tax reporting while often continuing to use straight-line depreciation for their financial statements.¹³ This legislative change was a response to criticisms that companies were being overtaxed on capital and led to the increased discussion and adoption of methods like double declining balance for tax benefits.¹¹, ¹²

Key Takeaways

• The double declining balance method is an accelerated depreciation technique that recognizes a larger portion of an asset's cost as expense in its early years.
• It is suitable for assets that lose value or productivity quickly after acquisition.
• This method can result in lower taxable income and increased cash flow in the initial years of an asset's life.
• Unlike straight-line depreciation, it does not directly consider the salvage value in the annual calculation, though the asset cannot be depreciated below its salvage value.
• The total depreciation recognized over the asset's useful life is the same as other methods, assuming the same salvage value.

Formula and Calculation

The double declining balance method calculates depreciation expense by applying twice the straight-line depreciation rate to the asset's book value at the beginning of each period.

First, calculate the straight-line depreciation rate:

Next, determine the double declining balance rate:

Finally, calculate the periodic depreciation expense:

Where:

• Beginning Book Value: The asset's cost minus its accumulated depreciation at the start of the period.
• Useful Life in Years: The estimated number of years the asset is expected to be in service.

It is important to note that depreciation stops when the asset's book value equals its salvage value.

Interpreting the Double Declining Balance Method

The double declining balance method reflects the idea that many assets are more productive and lose more of their economic value during their initial years of operation. For example, a new delivery truck will likely perform at its peak and incur more wear and tear in its first few years, thus losing value more quickly. By front-loading the depreciation expense, this method aims to better match the expense with the revenue-generating potential of the asset. This approach can present a more accurate picture of an asset's declining value and its contribution to operations on a company's income statement. The choice of depreciation method significantly impacts reported financial statements and related financial ratios.

Hypothetical Example

Assume a company purchases new manufacturing equipment for $100,000. It has an estimated useful life of 5 years and an estimated salvage value of $10,000.

1. Calculate Straight-Line Rate: $$\text{Straight-Line Rate} = \frac{1}{5 \text{ years}} = 0.20 \text{ or } 20\%$$
2. Calculate Double Declining Balance Rate: $$\text{Double Declining Balance Rate} = 20\% \times 2 = 40\%$$

*In Year 5, the calculation of $12,960 x 40% = $5,184 would bring the book value below the $10,000 salvage value. Therefore, only $2,960 ($12,960 - $10,000) is depreciated to reach the salvage value, and the book value at the end of Year 5 is $10,000.

Practical Applications

The double declining balance method is often used by businesses for tax purposes. By allowing larger depreciation expense deductions in the earlier years of an asset's life, companies can reduce their taxable income and thus their tax liability in those periods. This can improve immediate cash flow, which can be particularly beneficial for businesses looking to reinvest funds into new capital expenditure or growth initiatives. The Internal Revenue Service (IRS) provides detailed guidance on depreciation methods, including accelerated systems, in publications like IRS Publication 946, "How To Depreciate Property."⁹, ¹⁰ This publication outlines the rules for recovering the cost of business or income-producing property through depreciation deductions.⁷, ⁸

From an accounting perspective, the Financial Accounting Standards Board (FASB), through its Accounting Standards Codification (ASC) Topic 360, "Property, Plant, and Equipment," provides guidance on how companies should account for long-lived assets, including their acquisition, depreciation, impairment, and disposal.⁵, ⁶ This ensures that companies consistently apply depreciation methods and accurately reflect the value of their tangible assets on their balance sheet.

Limitations and Criticisms

While the double declining balance method offers immediate tax advantages and aligns with the concept of higher asset utility in early years, it has certain limitations. One major drawback is that it can reduce taxable income significantly in the early years, which may lead to reduced tax savings in later years, potentially limiting future cash flow benefits.³, ⁴ Additionally, the faster write-off of assets means a lower book value for the asset on the balance sheet in the initial years. If a business needs to sell the asset before the end of its useful life, the asset's market value might be higher than its remaining book value, which could result in a taxable gain on disposal.² Some critics also point out that accelerated depreciation, while providing tax incentives for investment, can distort the corporate tax system and impair efficiency in capital allocation if not carefully considered.¹

Double Declining Balance vs. Straight-Line Depreciation

The primary distinction between the double declining balance method and straight-line depreciation lies in the timing of depreciation expense recognition.

Confusion often arises because both methods aim to allocate the cost of an asset over its useful life. However, they achieve this allocation with different timing, which impacts a company's reported profit, cash flow, and tax obligations over time. The double declining balance method is a type of accelerated depreciation, designed to reflect quicker asset value decline, while straight-line depreciation assumes a constant rate of wear and tear.

FAQs

What type of assets are best suited for the double declining balance method?

The double declining balance method is typically best suited for assets that lose a greater portion of their value or productive capacity in their earlier years. Examples include vehicles, computers, and certain types of machinery that become obsolete or less efficient quickly.

Does the double declining balance method result in more total depreciation over an asset's life?

No, the double declining balance method does not result in more total depreciation. The total amount of depreciation recognized over the asset's entire useful life will be the same as with other methods like straight-line depreciation, assuming the same cost and salvage value. It only changes the timing of when the depreciation expense is recognized.

Why would a company choose double declining balance over straight-line depreciation?

A company might choose the double declining balance method to realize greater tax deductions in the early years of an asset's life, which can reduce taxable income and improve cash flow during those periods. This can be advantageous if the company anticipates higher revenues in the early years of the asset or wants to reinvest tax savings into other operations.

Is the double declining balance method allowed under GAAP?

Yes, the double declining balance method is an acceptable depreciation method under Generally Accepted Accounting Principles (GAAP). GAAP requires that depreciation methods be systematic and rational in allocating the cost of an asset over its useful life. The Financial Accounting Standards Board (FASB) provides guidance on property, plant, and equipment within its Accounting Standards Codification.