What is the Diminishing Balance Method?
The diminishing balance method is a method of calculating the depreciation expense of an asset for each accounting period. The diminishing balance method is a technique of computing depreciation at a particular yearly percentage on the asset’s previous-year balance. The diminishing balance method is also known as the declining balance method. The diminishing balance method is used for computing depreciation on an asset for tax purposes.
Under this method, the depreciable amount of an asset is charged to the Profit & Loss Account of the year in which it is acquired. The rate of depreciation is applied to the diminishing value of the asset.
Depreciation is applied at a fixed proportion to the book value of the asset according to the Diminishing Balance Method. It’s also known as the Written-down Value Method or Reducing Balance Method, and it works like this: as the book value decreases over time, so does its written-down value. This method is also known as the double-declining balance method.
The diminishing balance method results in higher depreciation deductions in the earlier years of an asset’s life, and lower depreciation deductions in the later years. The diminishing balance rate is applied to the undepreciated balance of the asset.
Meaning of Declining Balance Depreciation
The way to depreciate a fixed proportion of the book value of an asset each accounting year until it reaches scrap value is understood as diminishing balance depreciation.
The diminishing balance method is a technique in which the price paid for an asset is used to calculate depreciation. This procedure calculates depreciation by taking the reduction in book value each year.
The company incurs depreciation on decreasing book value each year through the Diminishing Balance method. The company charges depreciation on the purchase price of an asset using the straight-line method, whereas it does so on decreasing book value using the diminishing balance technique.
The balance method of depreciation reduces the value of an asset’s cost over time. As a result, in the early years, it lowers more rapidly, and in later years, it decreases at a slower rate. This technique is used by firms for assets that lose their worth quickly or are no longer useful.
Formula to Calculate Depreciation Value via Diminishing Balance Method
The formula for determining depreciation value using the declining balance method is-
Depreciation Value: (Net Book Value – Scrap Value) x Depreciation Rate
Calculating Depreciation Expense using the Diminishing Balance Method
First of all, you need to calculate the depreciation expense through the formula
Depreciation Value = (Net Book Value – Scrap Value) Depreciation Rate
And then you should subtract the depreciation cost from the asset’s current book value for finding out the remaining book value of an asset.
These two steps are repeatedly used throughout the asset’s useful life. In the final year of the asset’s useful life, you should subtract the residual value from the current book value and record the amount of depreciation.
Afterward, you should keep on using these two steps repeatedly throughout the useful life of an asset. Finally, in the last year of the useful life of the asset, you will be required to subtract the residual value from the current book value and then ultimately you need to record the amount of depreciation.
1. Net Book Value
It is the value of an asset after it has been fully depreciated. For example, if an asset has a purchase price of $1,000 and has been depreciated by $500 using the diminishing balance method, then its net book value would be $500.
2. Scrap Value
It is the estimated value of an asset at the end of its useful life. For example, if an asset has a purchase price of $1,000 and is expected to have a scrap value of $100 at the end of its useful life, then its scrap value would be $100.
3. Depreciation Rate
It is the rate at which an asset loses its value over time. For example, if an asset has a depreciation rate of 10%, then its value would be reduced by 10% each year.
Diminishing Balance Method Example
Let’s say that a company buys a machine for $100,000. The machine has an expected life of 10 years and a salvage value of $10,000. The company uses the diminishing balance method to depreciate the machine.
The depreciation rate is calculated by:
Depreciation Rate = 2 / (Expected Life in Years)
Therefore, the depreciation rate for this machine would be:
Depreciation Rate = 2 / (10)
Depreciation Rate = 0.2 or 20%
The first year’s depreciation expense would be calculated by:
Depreciation Expense = (Asset Cost – Salvage Value) * Depreciation Rate
Therefore, the depreciation expense for the first year would be:
Depreciation Expense = ($100,000 – $10,000) * 0.2
Depreciation Expense = $18,000
The second year’s depreciation expense would be calculated by:
Depreciation Expense = (Asset Cost – Accumulated Depreciation) * Depreciation Rate
Therefore, the depreciation expense for the second year would be:
Depreciation Expense = ($100,000 – $18,000) * 0.2
Depreciation Expense = $16,200
This process would continue until the final year when the machine is expected to be sold for its salvage value.
Advantages of Diminishing Balance Method
1. Easy Calculation
The Diminishing Balance method is easy to calculate as it only requires the depreciation rate and the net book value of the asset.
2. Higher Depreciation in Early Years
The Diminishing Balance method results in a higher depreciation expense in the early years of an asset’s life. This is advantageous because it results in a higher tax deduction in the early years when the company is most likely to be in a higher tax bracket.
3. More Realistic
The Diminishing Balance method more accurately reflects the pattern of an asset’s usage and its resulting wear and tear.
4. Matching Principle
The Diminishing Balance method adheres to the matching principle which states that expenses should be matched with revenues in the period in which they are incurred.
5. Higher Net Book Value
The Diminishing Balance method results in a higher net book value for an asset at the end of its life. This is advantageous because it means that the asset can be sold for a higher price.
Disadvantages of Diminishing Balance Method
1. Tedious in estimating the appropriate rate of depreciation
One of the main disadvantages of diminishing balance depreciation is that it can be tedious in estimating the appropriate rate of depreciation. This is because the depreciation rate must be recalculated each year to reflect the changes in the asset’s value.
2. Does not accurately reflect the pattern of an asset’s usage
Another disadvantage of diminishing balance depreciation is that it does not accurately reflect the pattern of an asset’s usage. This is because the depreciation expense is calculated using a fixed rate regardless of how much the asset is actually used.
3. Lower net income during initial years
The diminishing balance depreciation method results in a lower net income during the initial years of an asset’s life. This is disadvantageous because it means that the company will have to pay taxes on a higher amount of income.
4. Lower depreciation expense in later years
The diminishing balance depreciation method also results in a lower depreciation expense in the later years of an asset’s life. This is disadvantageous because it means that the company will have to pay taxes on a higher amount of income.
5. Not allowed for tax purposes in some countries
The diminishing balance depreciation method is not allowed for tax purposes in some countries. This means that companies cannot take advantage of the tax benefits that this method offers.
6. Requires a large amount of data
The diminishing balance depreciation method requires a large amount of data in order to be accurately calculated. This can be disadvantageous for companies who do not have access to this data or who do not have the resources to compile it.
7. Not ideal for assets like plants and machinery
The diminishing balance depreciation method is not ideal for assets like plants and machinery. This is because these assets typically have a higher value in the early years and a lower value in the later years.
Conclusion!
In the end, it can be said that diminishing balance depreciation is useful in many ways but it has some drawbacks too which should be considered before using it.
You should use it when you want to take advantage of the tax benefits that it offers or when you want to more accurately reflect the pattern of an asset’s usage.
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