Principles of Accounting: The reducing balance/diminishing balance method

• As discussed in this topic there are number of ways in which depreciation can be calculated
• The reducing balance method is one of these methods
• It is also known as the diminishing balance method
• A fixed percentage is deducted from the first from cost then subsequently from the net book value of the asset each period
• The result is that the amount of depreciation for the asset decreases each year
• Consider the example shown below of a lorry bought for 10 000 and depreciated at a rate of 20% each year over 4 years

• As you can see the depreciation cost for each year drecreases
• This is likely to be more indicative of certain assets whose maintenance cost is low in the early years but increases with time
• The following formula is used to find out the percentage to be used:
• r=1-\sqrt[n]{\frac{s}{c}}
• Where:
• n is the estimated useful life in years
• s is the net residual value (this must be a significant amount or the answers will be absurd, since the depreciation rate would amount to nearly one)
• c is the cost of the asset
• r  is  the resultant rate of depreciation to be applied
• For example given that the useful life of an asset is 4 years, its cost $10 000 and residual value $256
• The rate of depreciation would be:
• r=1-\sqrt[4]{\frac{256}{10000}}
• 0.6
• That is 60%

Advantages

• It is easy to understand and implement
• Equalizes the burden of costs on the Income Statement by balancing maintenance costs and depreciation
• It is acceptable by tax authorities and widely recognised
• Matches cost of revenue for each period
• Can be used on short term assets that are susceptible to technology changes by writing off larger amounts in the early years

Disadvantages

• Calculating the rate of depreciation is complicated
• Makes historical comparison of profits from the Income Statement difficult
• Does not reflect the usage of the asset from year to year
• It requires that there be a large difference between the cost and residual value otherwise ridiculous depreciation percentages are yielded

To access more topics go to the Principles of Accounting Notes.