Starting a creative business is always exciting. However, a new business brings the responsibility of managing the fundamental and technical aspects of marketing, finance, etc. You will have to learn about the intricacies and functioning of these key divisions that will drive your company's growth.
Accounting is one such function that requires your attention. Several concepts have to be taken care of while you are preparing your books of accounts. These include various elements like assets, liabilities, taxes, and so on.
Assets are an essential part of any business, and understanding how they're recorded in the book of accounts is key. Most assets are subjected to depreciation.
Here’s everything you need to know about depreciation and the double-declining balance method of depreciation used by most organizations in the US.
The first step to understanding what is depreciation method you should use for your business is knowing what depreciation is. Depreciation is the process by which a particular asset's value is written off over a period of years. You can use several methods to calculate the annual depreciation value of a specific asset.
Companies generally use a declining balance method or a straight-line method to calculate the value of depreciation of an asset. The double-declining approach has gained much popularity recently and is also known as the accelerated depreciation method or the reducing balance method.
The double-declining balance method depreciates or reduces the asset's value twice as fast as the other methods. This method is more realistic as an asset's value falls drastically with a slight change in the technological environment. The amount of depreciation is calculated on the asset's present value, unlike other methods that consider its historical value.
If your company is using the double-declining balance method, the value of your assets will decline at a faster pace during the earlier years. The amount of depreciation will reduce as the asset gets old.
The straight-line method of depreciating assets is the most common and widely used due to its ease of calculation. The depreciation value or the amount remains the same every year. However, this concept is scientifically flawed as no asset can depreciate at the same rate every year.
If you use the double-declining balance method to calculate the value of depreciation, the value would be high in the initial years. However, it will reduce year after year as the asset gets older.
Also, if you use the straight-line method to calculate depreciation, the value of depreciation will be based on the purchase value or the asset's historical cost. On the other hand, the double-declining balance method considers the asset's book value to calculate its depreciation. In this case, the book value of the asset changes every year.
The straight-line method is a traditional method of calculating depreciation, whereas the double-declining balance method is more realistic. The latter has seen wider applicability in modern times.
Also know about Principal balance and its working principle.
Calculating the double-declining balance depreciation is quite easy. The formula that you can use is:
Depreciation = 2 X SLDP X BV,
SLDP - Straight-Line Depreciation Percentage
BV - Book Value of the asset at the beginning of the financial year
Every year, the value of depreciation will change as it is directly related to the asset's book value.
There are several benefits of using the double-declining balance method to calculate the value of depreciation. Some of these benefits are:
Generally, the efficiency of the assets is higher when they are purchased. You need to spend more on the maintenance of these assets over time, which is a tax-deductible cost in the US.
You can get a more significant tax write-off in the initial years as you won't be writing off any maintenance costs. Later, the amount of depreciation would reduce and the maintenance costs associated with the assets increase. The write-offs tend to become relatively stable with time.
In the initial years, you tend to get more money back from the tax write-offs. You can use this amount to offset the asset's purchase price. If you have taken a loan to finance the asset's purchase, you can quickly pay off a more significant chunk of that loan. The interest will also reduce if you pay a substantial portion of the debt at an early stage.
If you start writing off your asset early on, your tax obligation will reduce significantly. With every passing year, the income coming from that asset will also decrease. As a result, the effect will be balanced out.
Several organizations widely use the double-declining balance method. However, it has its share of drawbacks.
As a small business owner, you might find it intimidating to use the double-declining method to calculate depreciation. However, you can hire an accountant who can help you with the process, especially since you cannot afford to make any mistakes.
When you file your taxes, you have to predict your annual income. If you use the double-declining balance method, the book value of the assets will change every year. The changing values can affect your business forecasting function, and you might find it challenging to come to a fair prediction.
Suppose your business buys a piece of machinery at $40,000. The machinery is expected to last for about ten years. After ten years, the salvage value of your machinery would be $4,000. The depreciation, if calculated using the straight-line method, would amount to $3,600 per year.
The total value of depreciation for n years = Purchase price of the asset – Salvage value of the asset.
The depreciation value per year = Total depreciation / Life of the asset (in years)
Total depreciation for 10 years = $40,000 - $4,000 = $36,000
Depreciation for 1 year = $36,000 / 10 = $3600
Now, for applying the double-declining balance method, calculate the SLDP first. Here, it's 1/10 or 10%. Now, double the SLDP. This will come to 20%.
Now, start reducing 20% of the asset value every year. For year one, reduce $8,000 from $40,000. Currently, 20% of $32,000 will be reduced from the book value. The process has to be continued until you reach the asset's salvage value that becomes equal to the asset's book value.
It would be best if you made a note of the following things while using the double-declining balance method for depreciating your assets:
- You will always have an amount left over as the amount of depreciation is a percentage of the asset's book value.
- To depreciate the entire value of the asset, you will eventually have to switch to the straight-line method for calculating depreciation.
- Once you fully depreciate the asset's value, you have to record the salvage value of the asset and close the account.
As a business owner, you need to know that the transition from one accounting method to another is inevitable. You should ask your accountant about their approach to calculating the value of depreciation for different assets.
Depreciation is a critical aspect when it comes to recording assets in the books of accounts. As a small business owner, you should hire an accountant who can help you with the complexities involved with depreciation. This will relieve the burden of handling such a challenging task yourself.
However, you should be aware of the method your company uses to maintain its books of accounts. It's always best to have a rationale for why you're using a particular method and the purpose the method serves for your new business.