ZIMSEC O Level Principles of Accounts Notes: 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
YearDepreciation for the yearNet Book Value/Cost of asset
120008000
216006400
312805120
410244096
  • 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.

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