Double declining depreciation is a method used for calculating depreciation. It is generally used for assets where being new carries unusually high value. The double declining depreciation system simply means that over the accounting lifespan of the product, depreciation is calculated at twice the proportional rate.
Depreciation is the way in which companies are able to take account of the gradual loss in value of an asset, such as a machine, over time. This can be caused by wear and tear, an asset becoming obsolete, or other factors. Most countries have accountancy laws allowing businesses to artificially divide this loss of value over multiple years. Depending on the system, each year's loss can contribute to lower tax liabilities.
The simplest form of depreciation calculation is the straight-line method. Under this system, each asset is assigned a lifespan, often set down by tax law, rather than left entirely to the accountant's personal judgment. The total depreciation is the difference between the original value of the asset and its expected value at the end of the lifespan, known as the scrap value. Under straight-line, the annual loss of value recorded for the asset is 100% of the total depreciation, divided by the number of years in its lifespan.
For example, if a company buys an $11,000 machine and assigns it a five-year lifespan with a scrap value of $1,000, the annual depreciation will be recorded as 20% of the total $10,000 depreciation. This means that each year, the company lists $2,000 as annual depreciation and reduces the asset's listed value on the accounts, known as its book value, by $2,000. At the end of five years, the company stops recording depreciation, and the book value of the machine will be $1,000, thus having reached its scrap value. If the company later sells the machine for more than this scrap value, the excess will be considered profit and liable to tax.
Double declining depreciation is designed to take account of situations where an asset's true value drops disproportionately in its earliest years. There are two key differences. The first is that the annual depreciation is based on the current book value of the asset, rather than its original value. The second is that the annual depreciation rate takes the 100% divided by the number of years in the lifespan and doubles the result.
As an example, with a lifespan of five years, the annual depreciation rate is 40% of the book value, not 20% of the original value. With the $11,000 machine from the previous example, the first year's depreciation is 40% of $11,000, hence $4,400, leaving a book value of $6,600. In the second year the depreciation is not 40% of $11,000 but rather 40% of $6,600, hence $2,640, and the book value drops to $4,000.
The biggest difference in practice with double declining depreciation is that the book value of the asset will not always reach the scrap value at the same time that the assigned lifespan expires. Whether it reaches this earlier or later depends on the numbers involved. Because of this, depreciation automatically ends at the end of the assigned lifespan, or when the book value is equal to or lower than the scrap value, whichever happens first.
