What is Reducing Balance Method?
Reducing Balance Method, also known as declining balance depreciation or diminishing balance depreciation, the depreciation is charged at a fixed rate like straight line method (also known as fixed installment method or straight line depreciation). However, unlike fixed installment method, the rate percent is not calculated on cost of asset but on the book value of 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
What is Depreciation and its causes?
We all know that all fixed assets come with a price tag. Depreciation is something that consumes the value of that fixed asset with passage of time. It is an expense of services consumed in the same way as other expenses occur like payment of wages, electricity bill, etc. Depreciation lowers net profit as it is charged an expense in income statement. Net profit Margin also known as “Profit Margin” or “Net Profit Margin Ratio” is the percentage of revenue remaining after you have factored in for cost of goods sold, operating costs or expenses, taxes, interest, and preferred stock dividends, excluding common stock dividends. In other words it is ratio which 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 £6000 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 first year. Depreciation as such would be $2000 i.e. one third of the cost of the tractor. Profit would be reduced by £2000 and the value of the tractor in the balance sheet at the end of first year would diminish from £6000 to £4000.
And what about the diesel consumed by the tractor? Please note that both are expenses for a person, the difference being that diesel is consumed regularly whereas the expense of the tractor is spread over many years.
Causes of Depreciation
Economic factors, depletion, time and physical deterioration are the primary causes of depreciation. Each is briefly explained as following:
Wear and tear
Taking the example of tractor above, it is natural to expect that with passage of time and usage, its parts, tires, engine, etc will eventually wear off. How long it remains in service depends upon its quality, maintenance and usage among other things.
Erosion, Rust, Decay, etc
Land may suffer erosion by action of nature such as rain, wind, heat, etc. Similarly, the metals used in a motor vehicle will rust away.
Is there a possibility that the asset may be taken out of service even if it is in working condition. The answer is: Yes. Obsolescence and inadequacy are two major factors that contribute to this.
This is the process of becoming out of date. For example, there have been great technological advances in the field of computers. Both hardware and software undergo rapid updation making a computer’s hardware as well as software obsolete, and much of it is taken out of service within two to three years. This, however, in way implies that they are not in working condition and can be easily used by someone who cannot afford to buy a new piece.
This happens when the asset is put out of service because of the growth and changes in the size of the business. For example, a small boat operated by a business at a coastal resort will no longer serve its purpose once the resort becomes popular and the numbers of tourists increase significantly. Under such circumstances, the resort owner may opt for a larger boat to ferry passengers. It does not mean that the smaller boat has become obsolete; it is just that it has become inadequate for the present business.
This is self-explanatory as erosion, decay, rust, wear and tear; along with obsolescence and inadequacy all happen with passage of time. However, there are certain fixed assets who have a life fixed in legal terms. For example, you may lease a building for 10 years and after 10 years the amount you have paid as lease becomes zero. Often the term amortization instead of depreciation is used to denote depreciation of such assets.
Assets such as oil wells, mines, etc are of wasting character, as raw material is extracted from them to make something else or they are sold in their raw state to other businesses.
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. Reducing balance method of depreciation accurately gauges the depreciation as it is usually seen that assets possess higher productive values during the 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 require less maintenance. Reducing balance method of depreciation ensures the depreciation expenses accurately display an assets’ functionality, productivity and its ability to generate revenue for the organization.
How to Calculate Reducing Balance Method of Depreciation?
To calculate reducing balance depreciation, you need to have the knowledge of the following:
Asset cost refers to the asset’s net value at the start of an accounting period plus any additional cost incurred to make that asset ready for use. It is calculated by deducting the accumulated (total) depreciation from the cost of the fixed asset. Net Book Value is the asset’s net value at the start of an accounting period.
Residual value, also known as scrap or salvage value, refers to the value of the asset at the end of its life.
Depreciation factor correlates to the percentage the asset will depreciate with each passing year. For example, 1 is 100%, 0.5 is 50%.
Depreciation under reducing balance method may be calculated as follows:
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 expense.
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, you can see that depreciation expense under reducing balance method gradually reduces over the assets useful life. In case of fixed installment method the amount of annual depreciation remains the same whereas in the case of reducing balance method the amount of annual depreciation progressively declines.
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 its initial years of being put into service. Also, rapidly advancing technology makes computer obsolete rather fast. Using reducing balance method to calculate depreciation of 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 balances each other out. With progress of time, as the 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 of each year. A major shortcoming of this method is that it takes very long 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 used by income tax authorities for granting depreciation allowance to assess.
Formula for the Calculation of Depreciation Rate
The calculation of correct rate of depreciation is of paramount importance in reducing balance method of depreciation. 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
r = Rate of depreciation
n = Estimated useful life of asset
S = Residual value after the expiry of useful life
C = Original cost of asset
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
Primary Differences between Straight Line Method and Reducing Balance Method
Key differences between straight line method and reducing balance method are enumerated as following:
Straight line method
- The rate of depreciation and the amount remain constant
- Cost of assets each year forms the basis of determining depreciation percentage
- The value of an asset at the end of its life is zero.
- 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.
- Computation of depreciation under straight line method is relatively easy and straightforward
Reducing balance method
- The rate of depreciation remains unchanged but the amount gradually decreases
- Book value of assets forms the basis of determining depreciation percentage
- The value of an asset at the end of its life is never zero
- 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
- Computation of depreciation under reducing balancing method is always possible, but it comes with its own share of complexities.