Diminishing or Reducing Balance Method; Under this method, depreciation calculates at a certain percentage each year on the balance of the asset which is brought forward from the previous year. The article from the calculation of Depreciation methods, the chapter of Depreciation in the Accounting Book. The amount of depreciation charged on each period is not fixed but it goes on decreasing gradually as the beginning balance of the asset in each year will reduce. Thus, the amount of depreciation becomes higher at the earlier periods and becomes gradually lower in subsequent periods, when repairs and maintenance charges increase gradually.
Diminishing or Reducing Balance Method of Depreciation: Meaning, Definition, Advantages, Disadvantages, and Differences.
What is the Diminishing or Reducing Balance Method? Reducing Balance Method, also known as declining balance depreciation or diminishing balance depreciation, the depreciation charges at a fixed rate like the straight-line method (also known as fixed installment method or straight-line depreciation). However, unlike the fixed installment method, the rate percent not calculates the cost of assets but on the book value of the asset, which in turn calculates by subtracting depreciation from its cost.
Under reducing-balance, the rate of depreciation is deliberately calculated to be higher, so most of the benefits of deducting the depreciation expense are seen early on. Typically, the percentages used are 200% (the double-declining balance formula) and 150%. Because you’re subtracting a different amount every year, you can’t simply repeat the same calculation each year, as you can with the straight-line method. As mentioned earlier, this approach is particularly useful for a property whose value will decrease rapidly after you acquire it.
Definition of Diminishing or Reducing Balance Method:
Diminishing Balance Method of Depreciation also called as reducing balance method where assets depreciate at a higher rate in the initial years than in the subsequent years. Under this method, a constant rate of depreciation applies to an asset’s (declining) book value each year. This method results in accelerated depreciation and results in higher depreciation values in the early years of the life of an asset.
The book value of an asset obtains by deducting depreciation from its cost. The book value of assets gradually reduces on account of charging depreciation. Since the depreciation rate percent applies to reduce the balance of assets, this method calls reducing balance method or diminishing balance method.
Under the 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 for 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 the early years when repair expenses are less the depreciation is more. As the asset gets older repair charges on its increase and the number of depreciation decreases. So the combined effect of both these costs remains almost constant on the profit and loss of each year.
Advantages of Diminishing or Reducing Balance Method:
The following advantages below are;
- It is a simple and easy method.
- Every year, there is an equal burden for using the asset. This is because depreciation goes on decreasing every year whereas the cost of repairs increases.
- The obsolescence problem gives due care since the major part of the depreciation charges in earlier years and the management may find it easy to replace the asset.
- All items including additions are added together and depreciated at the same rate.
- Income tax authorities recognize this method.
Disadvantages of Diminishing or Reducing Balance Method:
The following disadvantages below are;
- It is difficult to determine an appropriate rate of depreciation.
- The value of the asset cannot be brought down to zero.
- It results in lower Net Income during the initial years of an asset as Depreciation is higher initially.
- It is not an ideal method for those assets which don’t lose their value quickly like Equipment and Machinery.
- Depreciation is neither based on the use of the asset nor distributed evenly throughout the useful life of the asset.
Differences between the Straight Line Method and Diminishing or Reducing Balance Method:
Key differences between the straight-line method and reducing balance method enumerate as following;
Differences in Straight-line method:
- Meaning; Under this method, the cost of an asset uniformly fixed divides into the number of years of the useful life of an asset.
- The rate of depreciation and the amount remain constant.
- The cost of assets each year forms the basis of determining the depreciation percentage.
- As the asset ages, the cost of its repair goes up. But as mentioned in point number one, the depreciation amount remains unchanged. This diminishes annual profit.
- The value of an asset at the end of its life is zero.
- The computation of depreciation under the straight-line method is relatively easy and straightforward.
- Straight Line Depreciation Method is ideal for those assets which require negligible maintenance expenses and are not prone to technological obsolescence.
Differences in Diminishing or Reducing balance method:
- Meaning; Under this method, a constant rate applies over the assets declining book value (Cost minus Accumulated Depreciation).
- The rate of depreciation remains unchanged but the amount gradually decreases.
- The book value of assets forms the basis of determining depreciation percentage.
- As the asset ages, the cost of its repair goes up, but so does the depreciation amount. These two balance each other and hence there is little or no effect on annual profit/loss.
- The value of an asset at the end of its life is never zero.
- Computation of depreciation under reducing balancing method is always possible, but it comes with its share of complexities.
- Declining Balance Method is appropriate for assets that require more repairs and maintenance expenses as they get older and also for those assets which are prone to technological obsolescence as it results in higher depreciation during the initial years of an asset’s life.