The declining balance method of depreciation produces
What is the reducing balance method? The reducing balance method of depreciation, also known as declining balance depreciation or diminishing balance depreciation, is a way of accounting for assets over a period of time. It is charged at a fixed rate, like the straight line method (also known as fixed instalment method or straight line… Show
Sep 16, 2020 What is the reducing balance method?The reducing balance method of depreciation, also known as declining balance depreciation or diminishing balance depreciation, is a way of accounting for assets over a period of time. It is charged at a fixed rate, like the straight line method (also known as fixed instalment method or straight line depreciation). However, unlike the fixed instalment method, the percent rate is not calculated on the cost of an asset but on the book value of the asset, which in turn is calculated by subtracting depreciation from its cost. However, before we delve any further, it is important to look into the definition and cause of depreciation itself. A recap: what is depreciation and what are its causes?We all know that all fixed assets (illiquid and long-term purchases such as land or machinery) come with a price tag. Depreciation is something that consumes the value of that fixed asset with the passage of time. It is an expense of services consumed in the same way as other expenses occur like payment of wages, electricity, etc. Depreciation lowers net profit as it is charged as an expense in the income statement. Net profit margin, also known as the �profit margin� or �net profit margin ratio� is the percentage of revenue remaining after you have factored in cost of goods sold, operating costs or expenses, taxes, interest, and preferred stock dividends, excluding common stock dividends. In other words, it is a ratio that shows the percentage of profit a company produces from its total revenue – or what percentage of your sales is actual profit. For example, if a tractor cost �6,000 and it is assumed that it will be in service for three years, it means that one-third of its value is consumed at the end of the first year. Depreciation as such would be �2,000 i.e. one third of the cost of the tractor. Profit would be reduced by �2,000 and the value of the tractor in the balance sheet at the end of the first year would diminish from �6,000 to �4,000. And what about the diesel consumed by the tractor? Diesel is consumed regularly, whereas the expense of the tractor is spread over many years. What causes depreciation?Economic factors, depletion, time and physical deterioration are the primary causes of depreciation. Each is briefly explained as following: Physical deterioration
The reducing balance method of depreciation results in declining depreciation expenses with each accounting period. In other words, it charges depreciation at a higher rate in the earlier years of an asset. The amount of depreciation reduces as the life of the asset progresses. The reducing balance method of depreciation accurately gauges the depreciation, as it is usually seen that assets possess higher productive values during their initial years. For example, a new machine will have higher functionality when it is new and more likely to generate additional revenue for the company, and also requires less maintenance. The reducing balance method of depreciation ensures the depreciation expenses accurately display an asset�s functionality, productivity and its ability to generate revenue for the organisation. Calculating depreciation using the reducing balance methodTo calculate reducing balance depreciation, you need to have knowledge of the following:
Depreciation per annum = (net book value – residual value) x depreciation factor (rate %). Subtract the depreciation charge from the current book value to calculate the remaining book value. The above mentioned two steps are to be repeated every year till the asset is in use. In the final year for which the asset will be used, you should subtract the residual value from the current book value – the resulting amount should be treated as an expense. For example, a company buys a van for �5,000. It is estimated that the van is likely to lose 40% of its value each year, and the scrap value will be �1,000. Calculate the first five years of depreciation using the reducing balance method calculation. Using the formula: Depreciation per annum = (net book Value – residual value) x depreciation factor (rate %) Example 1 – An asset�s useful life is determined to be three years. Cost of the asset is �2,000. Residual value is �500. Rate of depreciation is 50%. How will you calculate the depreciation expense for these three years?
As is evident from the above example, the depreciation expense under the reducing balance method gradually reduces over the asset�s useful life. In the case of the fixed instalment method, the amount of annual depreciation remains the same – whereas in the case of the reducing balance method the amount of annual depreciation progressively declines. The reducing balance method of depreciation is most appropriate in cases of assets that offer higher productivity during their initial years. Computers, for example, have better functionality during their initial years of being in service.Also, advancing technology makes computersrapidly obsolete. Using the reducing balance method to calculate depreciation of a computer ensures that higher depreciation is charged in initial years of its operation. Under this method the real cost of using an asset is the sum total of depreciation and the repair cost associated with the equipment or the machinery. This is a more reliable method, as in initial years the high rate of depreciation and low maintenance cost balance each other out. With the progress of time, as an asset gets older, the depreciation rate lowers but the maintenance cost goes up and, as such, the combined effect of both these costs remain almost constant on the profit and loss statement for each year. A major shortcoming of this method is that it takes a very long time to determine the residual value, or scrap value of an asset. The time period can be shortened, but then the depreciation rate would have to be much higher, which can put excess burden during the initial years. This method is often used by income tax authorities for granting depreciation allowances. Calculating the depreciation rateCorrectly calculating depreciation is of paramount importance when it comes to the reducing balance method. Please use the formula given below to calculate the depreciation rate. When the cost of asset, residual value and useful life of an asset is given: r = 1 – (S/C)1/n Where: r = Rate of depreciation n = Estimated useful life of asset S = Residual value after the expiry of useful life C = Original cost of asset Example 2: If n = 3 years, S = �64,000 and C = �1,000,000 calculate rate of depreciation. r = 1 – (64,000/1,000,000)1/3 = 1 – 40/100 = 60/100 = 60% Key differences between the straight line method and reducing balance methodKey differences between straight line method and reducing balance method are: Straight line method
Reducing balance method
Which method is known as declining balance method?The reducing-balance method, also known as the declining-balance method, in the initial years of an asset's “service.” As with the straight-line method, you apply the same depreciation rate each year to what's called the “adjusted basis” of your property.
Why is declining balance depreciation important?The reducing balance method of depreciation is most useful when an asset has higher utility or productivity at the start of its useful life, as it results in depreciation expenses that reflect the assets' productivity, functionality, and capacity to generate revenue.
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