The declining balance method is a way of measuring the loss in value of a fixed asset, such as a piece of equipment. Specifically, this is a common method of measuring the loss in value of heavy machinery. The declining balance method is one of the most popular choices for determining depreciation costs.
Companies must keep track of the loss in value of assets for a number of reasons. One of the biggest reasons is that investors and lenders demand an accurate account of the company’s assets before investing. Without the declining balance method, or some other method of evaluating value lost, the company cannot provide that accurate picture. Depreciation costs are generally listed on a company's earnings statement.
To understand how a declining balance method works, it is first necessary to understand how depreciation works. The raw materials in a machine or other item is usually worth something, even as salvage, so hardly anything built to last will depreciate totally. The difference between the acquisition price and the salvage price is the total potential depreciation. If a machine costs $11,000 US Dollars (USD) new, and has a salvage value at the end of its useful life of $1,000 USD, the total depreciation over it's life would be $10,000 USD.
A straight-line depreciation computation is probably the most simple method, and perhaps more widely used than the declining balance method. However, this method is not always the most accurate. It calculates depreciation based on the total depreciation potential, divided by the expected lifespan. This fixed number is then subtracted from the beginning of the year book value to provide the depreciation cost.
A declining balance method takes into account that the first year of an item's life is often the year it loses the most value. This rate is determined by taking the number 100 and dividing it by the number of expected number of years it can be used. If a piece of machinery has a lifespan of 20 years, this number would be 5 because it depreciates 5 percent each year for 20 years.
That percentage is then taken from the book value each year. For example, if there is a piece of equipment with $10,000 in total depreciation, 5 percent would be taken off that figure each year. After the first year, depreciation would make the asset worth $9,500 USD. At the end of the second year, it would be worth $9,025 USD and so on.
A declining balance method can also be tweaked slightly into something called the double declining balance method. Using the previous example, instead of depreciating by 5 percent every year, the asset would be subjected to a 10-percent level of depreciation. Some say this is an even more accurate picture of depreciation, but it may depend on the piece of equipment or machinery.