As your company grows, you may want more granular insight into financial areas such as expenses, revenue, and asset valuation. Some businesses even need to report this information to investors or shareholders.
Understanding the financial workings of your business can not only help you run your company more efficiently, but it can help you in other areas such as securing additional funding.
Depreciation—or the lost value of assets over time—is an important and necessary process that will allow you to more accurately estimate the value of your business assets. For example, when you purchase a new machine for $50,000, you know it’s worth $50,000 at that time, but how much would it be worth 3 years from now?
Obviously, as time progresses and assets are used, their value decreases—which is the principle behind depreciation.
The challenge for business owners is how to calculate depreciation. There are multiple methods for depreciating assets within a business. This guide will focus primarily on the double declining balance (DDB) method.
What Is the DDB Method?
The double declining method is an alternative calculation to the straight-line method, which tracks the same amount of loss each year. With the straight-line method, you can set a dollar amount for item depreciation and subtract that value from the asset annually.
With the double declining balance method, however, you factor in that an item loses its value faster during the first few years than the later years. You will assign a percentage lost to the items to calculate how much to deduct when factoring depreciation.
Calculating Double Declining Balance Depreciation
Calculating DDB might seem complicated at first, but once you see the formula in action, you can better understand why this option is used and when it is the best choice for your bookkeeping. First, start by calculating your straight-line depreciation rate (SLDR) for an item.
- A $20,000 item with 5 years of useful life would have a $4,000 depreciation.
- Your annual depreciation of $4,000 out of $20,000 is a depreciation rate of 20%.
Once you have your SLDR, you need to pull the book value for the year. The book value refers to the amount that you have already factored in for depreciation in your books. Each year, the book value should decrease because you continue to write off amounts for depreciation and factor them into the value of your assets.
- During the first year, an item’s book value is the same as what you paid for it. In this case, the book value is $20,000.
Now that you have all of the information, you can follow the formula for double declining balance depreciation.
- DDB = 2 x straight-line depreciation percent x book value
- DDB = (2 x 0.2) x $20,000
- DDB = $8,000
For the first year, you will write $8,000 off of the value of your new piece of equipment. During this time, you can also calculate the book value of your equipment for next year:
- $20,000 – $8,000 = $12,000
When you calculate the DDB formula for the second year, you will use this adjusted book value. Because you are working with a smaller book value than you were the previous year, your DDB is less, as you can see below.
- DDB (Year 2) = (2 x 0.2) x $12,000
- DDB (Year 2) = $4,800
The value for the item after that year is now $7,200. The item will lose less and less value each year because there is less to take out from the book value.
Pros and Cons of the Double Declining Depreciation Method
There are many benefits to opting for this method of depreciation tracking. Some people consider it more accurate than the straight-line method as it accounts for an initial major loss in value during its first year. When an item moves from new to used, it always loses a large percentage of its value.
However, this option has its limits. By opting to devalue your items early on, you are limiting the amount your company is worth. You are devaluing your assets, and they may become obsolete faster than you would like.
Additionally, you may need to pay more taxes in the later years because this method allows for greater tax deductions in the short run. Instead of deducting the same amount on your taxes annually (with straight-line depreciation), you will report lower and lower depreciation amounts with each passing year.
Finally, you will need to use straight-line depreciation to calculate DDB, and you will need to use it when your item has no value. You will never reach “zero value” with DDB because you always take out a percentage of what the asset is worth. When you sell an item for scrap, you will record its final value in your books to end its record.
Learn Which Accounting Methods Work for Your Business
As you learn more about bookkeeping and accounting, you will discover multiple ways to set up your books. Choose the methods that are best for your industry and business model to set yourself up for success. Whichever method you choose, stick with it: you could end-up redoing your books if you decide to change how you track depreciation over time.
To learn more about depreciation, check out our resource guide and let us help you.