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Reducing Balance Method of Depreciation:

Definition and Explanation:

Under reducing balance method, the depreciation is charged at a fixed rate like straight line method (also known as fixed installment method). But the rate percent is not calculated on cost of asset as is done under fixed installment method - it is calculated on the book value of asset. The book value of an asset is obtained by deducting depreciation from its cost. The book value of asset gradually reduces on account of charging depreciation. Since the depreciation rate per cent is applied on reducing balance of asset, this method is called reducing balance method or diminishing balance method. The calculation of depreciation under this method will be clear from the following example.

Example:

Suppose the cost of asset is $1,000 and rate of depreciation 10% p.a.

Cost of asset 1,000
Depreciation:  
1st year: 10% of 1,000 100
 
Book value 900
2nd year: 10% of 900 90
 
Book value 810
3rd year: 10% of 810 81
 
Book value 729
   

and so on.......

Under fixed installment method the amount of annual depreciation remains the same but under reducing balance method the amount of annual depreciation gradually reduces.

This method is especially suitable to assets with long life, e.g., plant and machinery, furniture, motor car etc.

Under this method the real cost of using an asset is the depreciation and repair expenses so this method gives better results because in early years when repair expenses are less the depreciation is more. As the asset gets older repair charges on it increases and the amount of depreciation decreases. So the combined effect of both these costs remain almost constant on the profit and loss of each year.

The great weakness of this method is that it takes very long time to write off an asset to approximately nil, unless a very high rate is used, in which case the burden on earlier years shall be excessive. This method is used by income tax authorities for granting depreciation allowance to assesses.

Formula for the Calculation of Depreciation Rate:

The calculation of correct rate of depreciation is very important under this method. Following formula should be applied under given conditions:

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%

Difference Between Straight Line Method and Reducing Balance Method:

Following are the main points of difference between straight line method and reducing balance method of depreciation:

Straight Line Method Reducing Balance Method
1. The rate and amount of depreciation remain the same each year. 1. The rate remains the same, but the amount of depreciation diminishes gradually.
2. Depreciation rate per cent is calculated on cost of assets each year 2. Depreciation rate per cent is calculated on book value of asset.
3. At the end of its life the value of asset is reduced to zero or scrap value. 3. The value of asset is never reduced to zero at the end of its life.
4. The older the asset the larger the cost of its repair. But the amount of depreciation remain the same each year. Hence, the total of depreciation and repairs increases every year. This reduces annual profit gradually. 4. The amount of depreciation decreases gradually, while the cost of repairs increases. So the total of depreciation and repairs remain more or less the same each year. Hence, it causes little or no change in annual profit/loss.
5. Computation of depreciation under straight line method is comparatively easy and simple. 5. Depreciation can be computed without any difficulty, but it is not easy and simple.
 

More study material from this topic:

Definition, explanation and causes of depreciation
Depreciation is not a matter of valuation but a means of cost allocation
Activity method of depreciation
Straight line method of depreciation
Sum of the years' digits method of depreciation
Reducing balance method
Annuity method
Depreciation fund method or sinking fund method
Insurance policy method
Revaluation method
Depletion method
Machine hour rate, mileage, and global method
Methods of recording depreciation
Reserves
Difference between general reserve and specific reserve
Difference between capital reserve and general reserve
Difference between reserve and reserve fund
Difference between provision and reserve

 

 
 

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Financial Accounting Topics


  Introduction to Accounting
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  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
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  Standard Costing and Variance Analysis
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 
 

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