Friday, July 15, 2016
Depreciation: Straight line Method Vs Double Declining methods
When a company buys a long lived asset, such as equipment, machine, etc., it is not considered as an expense in the financial statements of the company. In fact, it is treated as an asset in the balance sheet. The value of the asset is then considered decreasing with time and the part of value decreased year by year is mentioned in financial statement as the depreciation expense. The efficiency and the working capability of the long lived assets decrease due to their wear and tear with time. The rate of decrease in the asset value depends on the depreciation method, the given company has adopted. At the end of the useful life of the long lived assets, if any value remains underappreciated, that value is called the salvage value of the asset. This article can provide help with finance assignment as well as provide help with accounting assignment.
There are different methods of depreciating the long lived assets. Among them, the two most used methods are straight line method and double declining method. In each method, there is a specific way to capture the depreciation expense in the financial statements. These methods are based on the certain assumptions. Let’s discuss these methods using examples.
In case of straight line method, the value of the asset is assumed to be reduced uniformly throughout the life of the asset. So, the annual depreciation expense, in this case, is the total value of asset divided by the number of years of the useful life. For example, a company purchases a machine at the cost of $500,000 with five years of useful life. Here, machine is stated in the company’s balance sheet as an asset with the value of $500,000. Suppose the company uses the straight line method for depreciation. Then, the annual equal depreciation expense for each of five years will be $100,000 (=$500,000/5). At the end of five years, there will be no salvage value.
In case of double declining method, the depreciating rate is double than the straight line method. If the useful life is four years, the depreciating rate for the straight line method is 1 /4 while it is 1 /2 (=2*(1/4) for double declining method. Let’s have an example. For example, a company purchases a machine at the cost of $500,000 with five years of useful life. Here, machine is stated in the company’s balance sheet as an asset with the value of $500,000. Suppose the company uses the double declining line method for depreciation. Then, the annual depreciation expense for the first year will be $200,000 (= $500,000*(2/5)). For next year, the book value will be $300,000 after deducting the first year depreciation expense from the initial book value. Annual basis depreciation is shown below:
Year Beginning book value Depreciation expense Ending book value
1 $500,000 $ 200,000 $300,000
2 $300,000 $ 120,000 $180,000
3 $180,000 $ 72,000 $108,000
4 $108,000 $ 43,200 $64,800
5 $64,800 $ 25,920 $38,880
At the end of five years, there will be $38,880 as salvage value.
From these examples, it is clear that the annual depreciation expense is different over the life of the asset in these methods. Both methods cause the same total depreciation expenses over the life of the asset. The difference is in the timing of the recognition of the depreciation expense. These two methods influence and give impacts on the financial statements in a different way. Let’s have a look. It will help the finance essay writer to include more information about depreciation.
• In double declining method, more value of the long lived assets are depreciated in the early periods of the useful life as compared to straight line method. So, in double declining method, taxable income is less in early periods of the life of assets related to straight line method. So, the company using double declining method has lower taxable income, lower net income and lower net profit margin in the early years of the life of assets related to that of the company using the straight line method.
• Due to the less taxable income in the early periods of the life of assets related to straight line method, less tax is deducted in the company in early periods using the double declining method than that of the company using straight line method.
So, the value of depreciation expense influences the financial condition and financial performance of a company by altering the financial statements. Obviously it depends on the method of depreciation a company choose to apply. Apart from that, the estimations and assumptions made under these methods have influenced the financial statements to a great extent. In depreciation calculation, two factors have to be estimated. One is the useful life of the asset. Other is the salvage value. By changing these two factors, there will be significant change in the taxable income and net income. In turn, these alter different financial ratios, which measure the financial health of a company. This article will be useful in providing the finance assignment help.