2 Ways of Calculating The Allowance for Accountings

Accounting allowances are essential for depreciating assets over their useful life. There are two primary methods for calculating these allowances: the straight-line method and the declining balance method. Each has its advantages and is used in different accounting scenarios.

Method 1: Straight-line Allowance

The straight-line method allocates the same amount of depreciation expense each year over the asset's useful life. This method is simple and widely used in accounting.

Formula

Annual Allowance = (Initial Cost - Salvage Value) / Useful Life (in years)

How It Works

To calculate the straight-line allowance:

Determine the initial cost of the asset.
Estimate the salvage value (the expected value of the asset at the end of its useful life).
Decide on the useful life of the asset in years.
Subtract the salvage value from the initial cost to get the depreciable base.
Divide the depreciable base by the useful life to get the annual allowance.

Example

Suppose you purchase a machine for $10,000 with an expected salvage value of $1,000 and a useful life of 5 years.

Depreciable base = $10,000 - $1,000 = $9,000

Annual allowance = $9,000 / 5 years = $1,800 per year

The straight-line method provides a consistent annual expense, making it easier to budget and forecast cash flows.

Method 2: Declining Balance Allowance

The declining balance method allocates a larger amount of depreciation in the early years and smaller amounts in later years. This method reflects the idea that assets lose value more quickly in the beginning.

Formula

Annual Allowance = Book Value at Start of Year × Depreciation Rate

How It Works

To calculate the declining balance allowance:

Determine the initial cost of the asset.
Choose a depreciation rate (typically between 15% and 30%).
Calculate the annual allowance by multiplying the book value at the start of the year by the depreciation rate.
Repeat the process each year using the new book value.

Example

Using the same machine ($10,000 initial cost) with a 20% depreciation rate:

Year 1: $10,000 × 20% = $2,000

Book value after Year 1: $10,000 - $2,000 = $8,000

Year 2: $8,000 × 20% = $1,600

Book value after Year 2: $8,000 - $1,600 = $6,400

The declining balance method accelerates tax deductions in the early years, which can be beneficial for tax planning.

Comparison of Methods

Both methods have their advantages and are used in different accounting scenarios:

Aspect	Straight-line Method	Declining Balance Method
Calculation	Fixed annual amount	Varies each year based on book value
Tax Benefits	Consistent deductions	Accelerated deductions in early years
Accounting Matching Principle	Follows matching principle	Does not strictly follow matching principle
Use Cases	General use, especially for tangible assets	Useful for assets with high initial value

Choosing the right method depends on the specific needs of the business and the nature of the asset being depreciated.

Frequently Asked Questions

Which method is more commonly used?

The straight-line method is more commonly used because it provides consistent annual expenses, making it easier to budget and forecast.

Can I switch between methods during an asset's life?

Yes, you can switch methods if the circumstances change, but it's important to document the reason for the change and ensure it complies with accounting standards.

What is the salvage value?

The salvage value is the estimated residual value of the asset at the end of its useful life. It's used to calculate the depreciable base in the straight-line method.

How do I choose the right depreciation rate for the declining balance method?

The depreciation rate is typically determined by the asset's type and industry standards. Common rates range from 15% to 30%.