I’m going to work through a practice question that focuses on the declining balance method of depreciation. But since the question further instructs you to use a percentage that is three times what it would be under the straight-line method, I’m going to cover that method too. So even though I’m really only taking up one question, it’s a tough one. There’s a lot of learning packed into this video which could help you with several other questions as well.
Let’s start by going over three nuggets of knowledge. Nugget number one. What is depreciation? In this question, the company is investing $500,000 into a piece of equipment. But since the equipment is going to last the company eight years and presumably help it generate income over that time, the cost of the asset is gradually written off over those years. Now, there are two methods of appreciation which can be used. The straight-line method and the declining balance method.
Nugget number two. Know the straight-line method, which is the easiest method to understand. The straight-line method is quite simple because the exact same amount is depreciated every year. The equipment is being purchased for $500,000 and is expected to last eight years, at which time it will have a salvage value of $75,000. On a side note, if the term salvage value is new for you, it may help to think of it this way. The equipment probably isn’t worthless when the company is done with it. Maybe it can be resold or used as a trade in or spare parts. In other words, it still has some value. Now, if the equipment is being purchased for $500,000 and will be worth $75,000 in eight years, that means it will depreciate a total of $425,000 over that time. So we divide the total depreciation of 425,000 by eight years to determine that the annual depreciation is $53,125.
Check out the table on the screen. Does anything stand out to you? Well, notice that the same amount is depreciated every year. Kind of makes sense that it’s called the straight-line method, right? Also, notice that after depreciating $52,125 every year for eight years, the book value, which is what the asset is worth at that time, is equal to the salvage value of $75,000. While the straight-line method is an acceptable method to use, from a practical standpoint there is one major drawback, which is in most cases, a piece of equipment doesn’t actually depreciate evenly by the same amount each year. And if you ever bought a brand-new car, you probably know what I mean. A new car normally depreciates by more in the first year, even as you drive it off the lot, as compared to the second year, the eighth year, the 12th year, and so on. In other words, as the asset ages, there’s not as much annual depreciation.
Now, let’s get to the third and final nugget. The declining balance method addresses this drawback. With this method, the amount of depreciation is highest in year one, but then declines each year, like your new car would. This question says to use the declining balance method at three times the straight-line method. In some questions, you may get lucky and be provided with a percentage to use, but in this tough question, you have to calculate it. Under the straight-line method, recall, we would be depreciating $53,125 of $425,000 total depreciation in the first year, which works out to be 12.5%. So we multiply this percentage by three, as the question tells us to, to get 37.5%.
Now, before moving on, here are a couple potential pitfalls to watch out for. Number one. To get the percentage under the straight-line method, we are dividing the annual depreciation of $53,125 by the total depreciation of $425,000. Do not divide by the purchase price of $500,000 or you’ll obviously be wrong. Secondly, be careful. It isn’t always three times. It could have been two times or perhaps double the declining balance method. So beware of that.
Next, let’s crunch the numbers for the declining balance method by completing the table that you see on the screen. Remember, we’re being asked for the depreciation amount in year two. In year one, we multiply the beginning value of 500,000 by the depreciation rate of 37.5% and determine the first year’s depreciation to be $187,500. We deduct that from the book value at the beginning of the year, and an un-depreciated amount of $312,500 remains. In year two, we multiply 312,500 by 37.5% and determine a depreciation amount of $117,187.50 for that year.
There is no need to go any further because this is what the question is asking for. And since the depreciation amount declined in the second year and it is called the declining balance method, that’s a good sign. So let’s select this answer and we’re correct. Now, if you would’ve answered this question wrong, that’s okay. I promise, these get easier with practice.