REDUCING BALANCE METHOD OF DEPRECIATION — MEANING, ADVANTAGES AND DISADVANTAGES

The reducing balance method of depreciation is a depreciation method where a fixed percentage of the net book value of an asset is depreciated each year.

Just like a straight-line method of depreciation, a fixed percentage is charged in the reducing balance method of depreciation

However, unlike straight line depreciation where a fixed percentage is charged on the cost of an asset, the reducing balance method charges a fixed percentage on the net book value of the asset.

The net book value of an asset can be defined as the value at which a company records its asset on the balance sheet. It is calculated by subtracting the cost of an asset from its accumulated depreciation. It is expected that the net book value will equal the scrap value at the end of the useful life of an asset.

In reducing balance depreciation, the book value of a non-current asset at the beginning of the year is multiplied by a fixed percentage to determine the depreciation for the accounting year.

This procedure is repeated in subsequent years until the asset reaches its residual value or zero if it has no residual value.

One feature of reducing balance depreciation is that depreciation charges are higher in the early life of an asset than in the latter life of an asset.

This is because the net book value, which is used to calculate depreciation, decreases from year to year.

It must be noted that the reducing balance method is also called the diminishing balance method, declining balance method, and written down value method.

To calculate reducing the balance depreciation, the formula is as follows:

Depreciation=Net book value × Depreciation rate.

If the depreciation rate is not given, we can calculate it using the following :

$R=1-\sqrt[n]{\frac{S}{C}}$.

Where R is the depreciation charge.

n is estimated useful life.

S is scrap value or residual value.

C is assets cost

Example 1

A company bought equipment for N100,000. The equipment is expected to last for 3 years. Determine the equipment scrap value if the company's policy is to depreciate equipment at a rate of 20% per year.

Solution:

Year Book value (year start)DepreciationAccumulated depreciation Book value (year-end)
Year 1 N100,000N40,000N40,00N60,000
Year 2 N60,000N24,000N64,000N36,000
Year 3 N36,000N14,400N78,400N21,600

The equipment scrap value is N21,600 

Example 2 

At what rate should machinery depreciate given that it cost $\$1,000,000$ and its scrap value at the end of the 5 years is $\$200,000$

Solution:

Recalled that $R=1-\sqrt[n]{\frac{S}{C}}$.

$R=1-\sqrt[5]{\frac{200,000}{1,000,000}}$

$R=1-\sqrt[5]{0.2}$

$R=1-0.7248$

$R=0.2752$

Expressed in percentage, the rate of interest will be 27.52%.

Advantages of reducing balance method of depreciation

1. Depreciation is calculated according to service capacity: Under the reducing balance method of depreciation, the annual deprecation reduces gradually with the decrease in the service or revenue-earning potential of the asset.

2. It is simple to understand: Reducing balance depreciation is simple and easy to understand, as depreciation is only made annually based on the net book value of the asset.

3. Effective in matching cost and expenses: Reducing balance method of depreciation helps match revenue with expenses since more depreciation expenses are incurred in the earlier years and fewer depreciation expenses are charged in the latter years of an asset 

The matching concept of accounting states that revenue should be matched with the expenses incurred in generating the revenues in the period they occur.

That is, more expenses (depreciation) are allocated to the asset in the earlier years when the asset generates the most income; in the latter years, when the asset generates less revenue due to reduced effectiveness, fewer expenses (depreciation) are allocated

Disadvantages of reducing balance method of depreciation

1. Wrong assumption: Reducing balance method of depreciation is based on the belief that an asset service capacity will always decrease by a constant rate.

However, there is no certainty that an asset's service-generating capability would continue to decline at the same rate.

As a result, this method of depreciation might not be appropriate for all types of assets.

2. Dependent on salvage value: If the salvage value assets are small, the rate of depreciation will be very high.

Similarly, if the scrap value becomes zero, the reducing balance method of depreciation cannot be applied.

3. This is not suitable for long-lived assets: The reducing balance method of depreciation isn't appropriate for long-lived assets like buildings, whose value doesn't depreciate rapidly.

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