Reducing Balance Method
Reducing Balance Method: 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. Depreciation under reducing balance method may be calculated as follows:
Depreciation per annum = (Net Book Value – Residual Value) x Rate%
Where:
- Net Book Value is the asset’s net value at the start of an accounting period. It is calculated by deducting the accumulated (total) depreciation from the cost of the fixed asset.
- Residual Value is the estimated scrap value at the end of the useful life of the asset. As the residual value is expected to be recovered at the end of an asset’s useful life, there is no need to charge the portion of cost equaling the residual value.
- Rate of depreciation is defined according to the estimated pattern of an asset’s use over its life term.
Example of Reducing Balance Method
An asset has a useful life of 3 years.
Cost of the asset is $3,000.
Residual Value is $500.
Rate of depreciation is 50%.
Depreciation expense for the three years will be as follows:
| NBV | R.V | Rate | Depreciation | Accumalated Depreciation | |||||
| Year1: | (3000 | – | 500) | x | 50% | = | 1250 | 1250 | |
| Year2: | (1750 | – | 500) | x | 50% | = | 625 | 1875 | |
| Year3: | (1125 | – | 500) | x | 50% | = | 312.5* | 2187.5 |
*Under reducing balance method, depreciation for the last year of the asset’s useful life is the difference between net book value at the start of the period and the estimated residual value. This is to ensure that depreciation is charged in full.
As you can see from the above example, depreciation expense under reducing balance method progressively declines over the asset’s useful life.
Reducing Balance Method is appropriate where an asset has a higher utility in the earlier years of its life. Computer equipment for instance has better functionality in its early years. Computer equipment also becomes obsolete in a span of few years due to technological developments. Using reducing balance method to depreciate computer equipment would ensure that higher depreciation is charged in the earlier years of its operation.
Following are the main points of difference between straight line method and reducing balance method of depreciation:
Straight Line Method |
Reducing Balance Method |
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| 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. |