Firms spread out their investment costs in physical and fixed assets, such as plants and machinery, by providing for depreciation. There are several ways of accounting for depreciation, with the reducing balance method being one of them.
In today's business every entrepreneur must know how to manage their finances and assets in order to achieve maximum efficiency for their company. One important aspect of asset management is depreciation based on the method that will most accurately reflect the economic value of the property.
The reducing balance method is one of the most common methods of calculating depreciation. This article delves into what the reducing balance method is, how it works, and what benefits it provides to businesses. We will also discuss some of the factors to consider when choosing a depreciation method, and how using the reducing balance method can help entrepreneurs make finer financial decisions for their company.
Reducing balance method: Meaning
The reducing balance method of depreciation is a method in which depreciation is calculated at a fixed percentage rate of the book value of the assets. This results in higher depreciation expenses in the initial years, in line with the higher productivity showcased by the asset. As the useful life of the assets falls, the amount of depreciation also reduces. The reducing balance method is alternatively called the declining balance method or the diminishing balance method.
When should you use the reducing balance method?
This method is more suitable for those assets that become obsolete precipitously, such as technology-based products, computers, etc.
The reducing balance method is also ideal for assets that exhibit higher functionality and productivity and require lower maintenance in the beginning years, ensuring their higher revenue generation matches the higher depreciation computation.
What is the formula for the reducing balance method?
The reducing balance method formula in accounting is as follows:
| Depreciation = Net book value x Depreciation rate (%) |
In this formula, the net book value is the asset value at the beginning of the accounting period. Net asset value is calculated by deducting the amount of accumulated depreciation from the asset’s purchase cost.
Regarding the percentage rate of depreciation, some companies intentionally inflate it in order to get the desired benefits of the method as early as possible. For example, some firms sometimes use an interest rate of 200%, in which case they use the double declining balance method.
Some firms additionally estimate their asset's residual value, also called the salvage cost, at the end of its useful life. This residual cost is also deducted from the current book value while computing depreciation under the reducing balance method. In this case, the formula can be restated as:
| Depreciation = (Net book value - Residual value) x Depreciation rate (%) |
As for the depreciation rate, it is determined based on the use of the asset over its useful life.
Depreciation under the reducing balance system can also be calculated with an Excel sheet. In this scenario, the reducing balance method formula in excel is:
| Depreciation = DB (cost, salvage, life, period, [month]) |
In this formula, the cost is the initial investment cost, and the life is the estimated time the asset will be in use. The period represents the accounting period or the year for which the depreciation is being computed. The month is the number of months in the first accounting period, which can be left blank if the asset was used throughout the 12 months.
What is the diminishing balance method in depreciation? Example
We explain the reducing balance method with residual value with an example below.
Let us assume an asset with an initial price of £12,000 and a useful life of 5 years. It is expected that by the end of its use, the asset will have a residual value of £2,000. Further, we assume a depreciation rate of 40%.
| Period (years) | Net book value (NBV) (£) at the beginning of the year | Depreciation (£) |
|---|---|---|
| 1 | 12,000 | (12,000 – 2,000) * 0.4 = 4,000 |
| 2 | 12,000 – 4,000 = 8,000 | (8,000 – 2,000) * 0.4 = 2,400 |
| 3 | 8,000 – 2,400 = 5,600 | (5,600 – 2,000) * 0.4 = 1,440 |
| 4 | 5,600 – 1,440 = 4,160 | (4,160 – 2,000) * 0.4 = 864 |
| 5 | 4,160– 864 = 3,296 | (3,296 – 2,000) * 0.4 = 518.40 |
In the above example, the amount of depreciation falls in successive years. It starts at £4,000 in the first year and eventually falls to £518.40. However, in this example, by the end of the fifth year, the net book value becomes
| Net book value at end of the year = £3,296- £518.40 = £2,777.60 |
But this book value is above the estimated residual value of £2,000. As a result, the depreciation amount in the fifth year will be raised to £1,296. This is the difference between the net asset value at the beginning of the year (£3,296) and the salvage value (£2,000). Thus, reproducing the above table for the fifth year,
| 5 | 4,160– 864 = 3,296 | 3,296 – 2,000 = 1,296 |
Similarly, if the net asset value at the end of the year falls below the residual value, then depreciation will be reduced accordingly to maintain the difference. For instance, if the NBV at the beginning of the final year is £2,100 for an asset with a residual value of £2,000 and depreciation is £200, then only £100 (£2,100 – £2,000) would be recorded in the books.
*Be sure to also check out our Youtube video on cash flow management: *
Difference between reducing balance method and straight line method
One of the most popular and simple methods of calculating depreciation is the straight-line method. With this method, it is not necessary to calculate percentages; it is enough to determine the useful life of the asset as well as the salvage value at the end of the useful life. Once these are determined, the company calculates depreciation using the formula below and allocates the same amount of depreciation expense each year over the useful life of the asset.
| Depreciation = (cost of asset - salvage value) / useful life |
Straight-line method may be optimal for small businesses, but depending on the area in which they operate, executives may prefer larger depreciation deductions early on.
Reducing balance method: Advantages
The reducing-balance method has several advantages:
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Better alignment with replacement cycles: the reducing balance method is an accelerated method of recording depreciation, which is suitable for items that become obsolete quickly. By recognizing that an asset becomes less productive over time, the method provides a more accurate estimate of when it must be replaced.
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Greater accuracy in repair costs: The higher depreciation expense in the initial years balances the lower repair costs of assets.
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Lower taxable income: The declining balance method can result in lower taxable income in the early years of an asset's useful life. It is acceptable for all tax purposes; the higher depreciation expense in the initial years results in tax benefits due to lower net profit reporting, without any unfavourable impact on cash flows.
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More accurate reflection of the true economic value of the asset. The declining balance method calculates a higher depreciation in the early years of an asset's useful life. This is because the depreciation rate is applied to the book value of the asset, which decreases over time. By applying a higher depreciation rate in the early years, the method reflects a higher level of productivity which may better reflect the true economic value of the asset.
Reducing balance method: Disadvantages
Nevertheless, there are some disadvantages to using the reducing balance method for calculating depreciation:
- Higher depreciation in the early years of an asset's useful life leads to lower net income, which can cause serious cash flow problems. This is especially true for small businesses and any young company that does not make enough profit at the beginning. In that case, it might be worth considering other methods of depreciation.
- This method isunsuitable for assets that lose their value gradually, like office equipment; the straight-line method of depreciation is ideal in such cases.
- In some cases, the asset’s book value can be written down to such an extent that it is extremely outweighed by the market cost. This could result in the higher recording of profits when the asset is sold, misrepresenting the company’s financial position.
Key takeaways
Under accounting and tax laws, companies write down the cost of assets purchased over time.
Many companies use the easy-to-calculate straight-line method of depreciation, although it does not always allow for better cash flow management.
On the other hand, the reducing balance method results in a higher recording of depreciation expense in the earlier years of an asset’s use, with the amount declining over time. This method is often used when an asset is expected to depreciate faster in the first years of its useful life and its value decreases exponentially over time. For example, such assets might include vehicles, which may depreciate faster in the first years of use and then level off thereafter. In this case, the reducing balance method may be more appropriate.
Other types of assets, such as buildings or equipment with long useful lives, may depreciate more evenly over time, making the straight-line method a better choice.
Overall, both the straight-line and the reducing balance methods are acceptable ways to calculate depreciation, and the choice between them depends on the specific circumstances of your business.
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