Depreciation By Reducing Balance Method

Depreciation by Reducing Balance Method: A Comprehensive Guide

Depreciation is a crucial accounting concept that reflects the decrease in an asset's value over time due to wear and tear, obsolescence, or other factors. Understanding depreciation methods is essential for accurate financial reporting and tax calculations. This comprehensive guide delves into the reducing balance method, also known as the declining balance method or diminishing balance method, explaining its mechanics, advantages, disadvantages, and practical applications. We'll explore the calculations involved and answer frequently asked questions to solidify your understanding.

Introduction to Depreciation

Before diving into the reducing balance method, let's briefly review the core concept of depreciation. Assets, such as machinery, equipment, buildings, and vehicles, lose their value over their useful lives. Depreciation allocates this loss of value systematically over the asset's estimated useful life. This ensures that the company's financial statements accurately reflect the asset's current worth and doesn't overstate the company's assets. Several methods exist for calculating depreciation, each with its own characteristics and implications.

Understanding the Reducing Balance Method

The reducing balance method is an accelerated depreciation method. Unlike the straight-line method, which depreciates the asset evenly over its life, the reducing balance method depreciates a larger portion of the asset's value in the early years and a smaller portion in later years. This reflects the reality that assets often lose value more rapidly at the beginning of their lives.

The key feature of this method is that the depreciation expense is calculated as a fixed percentage of the remaining book value of the asset each year. The book value is the original cost of the asset less accumulated depreciation. Therefore, as the book value decreases each year, so does the depreciation expense.

Calculating Depreciation Using the Reducing Balance Method

The formula for calculating depreciation using the reducing balance method is:

Depreciation Expense = (Book Value at the Beginning of the Year) x (Depreciation Rate)

Where:

• Book Value at the Beginning of the Year: This is the asset's original cost minus accumulated depreciation from previous years. For the first year, this is simply the original cost.
• Depreciation Rate: This is a fixed percentage chosen by the company. It's often double the straight-line rate (though this is not mandatory). The depreciation rate should be selected based on the asset's estimated useful life and expected pattern of value decline. It must be less than 100%.

Let's illustrate this with an example:

Suppose a company purchases a machine for $100,000 with an estimated useful life of 5 years and a residual value (salvage value) of $10,000. They choose a depreciation rate of 40%.

Year 1:

• Book Value at Beginning of Year: $100,000
• Depreciation Expense: $100,000 x 40% = $40,000
• Book Value at End of Year: $100,000 - $40,000 = $60,000

Year 2:

• Book Value at Beginning of Year: $60,000
• Depreciation Expense: $60,000 x 40% = $24,000
• Book Value at End of Year: $60,000 - $24,000 = $36,000

Year 3:

• Book Value at Beginning of Year: $36,000
• Depreciation Expense: $36,000 x 40% = $14,400
• Book Value at End of Year: $36,000 - $14,400 = $21,600

Year 4:

• Book Value at Beginning of Year: $21,600
• Depreciation Expense: $21,600 x 40% = $8,640
• Book Value at End of Year: $21,600 - $8,640 = $12,960

Year 5:

• Book Value at Beginning of Year: $12,960
• Depreciation Expense: $12,960 x 40% = $5,184
• Book Value at End of Year: $12,960 - $5,184 = $7,776 (Note: This is above the salvage value of $10,000. This often happens and is discussed later).

This example demonstrates how the depreciation expense decreases each year as the book value diminishes. The total depreciation over five years is $40,000 + $24,000 + $14,400 + $8,640 + $5,184 = $92,224.

Handling Residual Value with the Reducing Balance Method

In the example above, the final book value ($7,776) exceeded the residual value ($10,000). This is a common issue with the reducing balance method. To address this, the depreciation expense in the final year should be adjusted to ensure the book value doesn't fall below the residual value. The depreciation expense in the final year should be calculated as the difference between the beginning book value and the residual value. In this case, the final year's depreciation would be $12,960 - $10,000 = $2,960.

Advantages of the Reducing Balance Method

• Reflects Reality: It more accurately reflects the faster rate of depreciation experienced by many assets in their early years. This is particularly relevant for assets that quickly become obsolete or lose value due to technological advancements.
• Tax Benefits: The higher depreciation expense in the early years can result in lower taxable income during those years, leading to tax savings. This is a significant advantage for businesses.
• Simplicity: The calculation itself is relatively straightforward, requiring only the initial cost, depreciation rate, and book value.

Disadvantages of the Reducing Balance Method

• Arbitrary Rate Selection: The choice of depreciation rate can significantly impact the depreciation expense and overall financial statements. There's no single "correct" rate; the selection is somewhat arbitrary.
• Inconsistent Depreciation: The declining depreciation expense can make it difficult to accurately forecast future cash flows and plan for asset replacements.
• Book Value May Exceed Residual Value: As demonstrated in the example, the book value may not reach the residual value within the asset's useful life. Adjustments are required to rectify this situation.

Comparison with Other Depreciation Methods

The reducing balance method is often compared to the straight-line method and the units of production method. The straight-line method provides a constant depreciation expense each year, while the units of production method bases depreciation on the actual use of the asset. Each method has its strengths and weaknesses, and the most suitable method depends on the specific asset and the company's accounting policies.

Scientific Explanation and Applicability

The reducing balance method's foundation lies in the observed pattern of asset value depreciation. Many assets experience a higher rate of value loss during their early years due to factors like intense usage and technological obsolescence. The method attempts to model this accelerated depreciation mathematically. However, it's crucial to remember that the chosen depreciation rate is an estimate. The actual depreciation might vary based on unforeseen circumstances. The applicability of this method is broad, encompassing a range of assets from machinery to computers. The choice often depends on industry norms and tax regulations.

Frequently Asked Questions (FAQ)

Q: What if I don't know the residual value?

A: If you don't have a reliable estimate for the residual value, you can either assume a value of zero or use a very low value. However, this will result in higher depreciation expenses.

Q: Can I change the depreciation rate during the asset's life?

A: While it's permissible in some accounting standards, changing the depreciation rate during the asset's life can complicate financial reporting and make it difficult to track the asset's depreciation accurately. It is generally recommended to stick with the initially chosen rate.

Q: Is the reducing balance method always better than the straight-line method?

A: No. The best method depends on the nature of the asset and the company's specific circumstances. The reducing balance method is advantageous when an asset depreciates more quickly in its early years. The straight-line method offers simplicity and consistency.

Q: How does the reducing balance method affect the company's financial statements?

A: The reducing balance method impacts the income statement (through depreciation expense) and the balance sheet (through the asset's book value and accumulated depreciation). Higher depreciation expenses in the early years result in lower net income, and a lower book value for the asset over time.

Conclusion

The reducing balance method is a valuable depreciation technique offering several advantages, particularly when dealing with assets that lose value quickly. While it has some limitations, its simplicity and ability to reflect real-world depreciation make it a widely used method. However, careful consideration must be given to the choice of depreciation rate and the potential need to adjust the final year's depreciation to account for residual value. Understanding the nuances of this method is crucial for anyone involved in financial accounting and asset management. Remember to always consult with accounting professionals to ensure you are complying with all relevant regulations and using the most appropriate method for your circumstances.