What is the Diminishing Balance Method?
The diminishing balance method, also known as the reducing balance method, is a method of calculating depreciation at a certain percentage each year on the balance of the asset which is brought from the previous year. The amount of depreciation imposed for each period is not fixed but it goes on decreasing moderately as the opening balance of the asset in each year will minimize. Hence, the amount of depreciation becomes higher at the beginning and gradually becomes slower in the subsequent period, while the charges of repairs and maintenance increase.
The method of calculating the diminishing balance method is almost similar to the fixed installment method with the exception that depreciation expenses are imposed each year at a fixed percentage, and not on the original cost of the asset but on the reducing opening balance of the asset as brought forward from the previous year. Therefore, the system of calculating depreciation is known as the diminishing balance method.
This method of calculating depreciation is suitable for those assets whose repairing charges increase as they become old. Under this method, the value of assets can never be equals to zero. This method is suitable for calculating assets like Plant & Machinery, buildings, boilers, etc.
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What is the Formula for Calculating Depreciation Value using the Diminishing Balance Method?
The formula to calculate depreciation value using the diminishing balance method is as follows:
Depreciation Value: (Net Book Value - Scrap Value) Depreciation Rate
How to calculate Depreciation Expense using the Diminishing Balance Method?
To calculate the depreciation expense using the diminishing balance method, you need to know the following information.
To calculate the depreciation expense using the diminishing balance method, you need to know the following information.
Net Book Value: It is the amount at which the asset value is recorded by business organizations in its financial records. Netbook value is calculated as the original cost of an asset, minus any accumulated depreciation, accumulated depletion, accumulated amortization, and accumulated impairment.
The original cost of an asset is referred to as the acquisition cost of an asset, which is the cost required not only to purchase or construct the asset but also includes the sales taxes, delivery charges. Customs duties, and set up costs.
The depreciation, depletion, or amortization related to the asset is the process by which the original cost of an asset is chargeable over its useful life, less any estimated salvage value. Therefore, the asset net book value should decline at a continuous and estimated rate over its useful life. At the end of its useful life, the net book value of an asset should be approximately equal to the salvage value.
Salvage Value: It is an amount that an asset is estimated to be worth at the end of its useful life.
Depreciation Rate: It is the rate at which the value of assets is reduced each year.
Using the information given above, you can easily calculate the depreciation expense in just two steps.
Step 1: Calculate the depreciation expense using the following formula:
Depreciation Value: (Net Book Value - Scrap Value) Depreciation Rate
Step 2: Subtract the depreciation cost from the asset’s current book value to determine 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.
Diminishing Balance Method Advantages
The calculation of depreciation amount using the diminishing balance method is quite easy. It does not require any special knowledge to calculate the depreciation expense using this method.
This method of calculating depreciation is applicable for valuable assets like buildings, plants and machinery, equipment, etc having a long life.
In this method, a higher amount of depreciation is deducted in the initial years. So, it helps to minimize the impact of obsolescence of assets.
The diminishing balance method of depreciation is acceptable by tax authorities. Hence, it provides tax benefits to the company.
Diminishing balance method balances the yearly burden on the profit and loss account in terms of both depreciation and repairs. The depreciation amount continues to decline while the expenses on repairs continues to increase. Hence the total expense against revenue over different years remains more or less the same.
Diminishing Balance Method Disadvantages
It is quite tedious to estimate the appropriate rate of depreciation.
The asset value cannot be brought down to zero.
As depreciation cost is high initially, it results in lower net income during the initial period.
Depreciation is neither based on the asset value nor evenly distributed throughout the useful life of an asset.
It is not an ideal method for the assets like Plant and Machinery as these assets do not lose their value easily.
Diminishing Balance Method Example
1. A company has brought a car that values INR 500,000 and the useful life of the car as expected by the buyers is ten years. And the residual value is expected to be INR 24,000.
Hence, using the diminishing method calculate the depreciation expenses.
The rate of depreciation is 60%
Solution: The formula says: Depreciation expenses = (Net Book Value – Residual Value) * Depreciation Rate
The value of the statement is as follows:
Net Book Value = INR 500,000 (in the first year which is equal to the cost of the car)
Residual Value = INR 24,000
Depreciation Rate = 60%
Therefore, the solution will be:
Depreciation Expense= (500, 000 – 24,000)* 60% = INR 2,85,600
2. A XYZ limited purchases a truck for ₹ 5,000. It was estimated by the company that each year the truck will lose 40% of its value and will be left with a scrap value of ₹ 1,000. Using the reducing balance method, calculate the depreciation expense for the first five years.
Solution:
Conclusion
A diminishing balance method is an accelerated method of calculating depreciation amount as it depreciates the asset value over its useful life. Although it is a bit complex to calculate depreciation in companion to the straight-line method but is highly useful for deferring tax payments and maintaining low profitability of the business in the initial years.
FAQs on Diminishing Balance Method
1. When is the Diminishing Balance Method for calculating depreciation amount used?
The diminishing balance method is used in the following two circumstances:
When the asset is used at a more rapid rate in the initial years of its useful life
When the business aims to recognize the higher expense in the early stage to minimize the profitability and thereby defer taxes.
2. What is the importance of diminishing balance methods?
The importance of calculating depreciation amount using the diminishing balance method can be best explained using the following situation:
Sometimes when a company aims to defer tax liability and reduce profitability in the initial years of asset useful life, this method is the best option for charging depreciation.
Also, in some cases, certain assets are more widely used during the initial years of their lives. Hence, by using a diminishing balance method of depreciation, and by imposing high costs during the first few years of an asset, the company is in a position to match the cost with the benefits obtained from using the asset in a better way.
3. What is the main difference between the straight-line method and the diminishing balance method of calculating depreciation amount?
The main difference between the reducing balance and straight-line methods of depreciation is that in the case of the diminishing balance method, depreciation amount is charged as a percentage of an asset's book value, whereas in the case of the straight-line method, the same amount is depreciated each year over the asset's useful life.
4. Which is the other method that assumes the fact that the assets should be depreciated from more than that in the early years and less in its later years?
The other method that assumes the fact that the asset must be depreciated for more in the early years than in the later years is called the written down value method. It also has other names that include Diminishing Balance Method or the Reducing Balance. In this method, the depreciation value is calculated in a fixed percentage year on the particular value of the decreasing book that is generally known as the WDV of that asset.
5. Although the written-down value method is said to be more realistic, yet in some places, it suffers from a few limitations. Name some of the limitations.
The written down value method has few limitations, and they are the following:
This particular method does not allow or take into consideration the interest of the capital that is invested in that asset.
It also does not deliver a replacement for that asset on the expiry of its life.
In this case, the formula can only be applied when there is a presence of a residual value of that asset.
6. Name as well as explain various types of reserves.
Revenue Reserves: Revenue reserves are the reserves that are created from several revenue profits that can arise from the normal activities for the various businesses which can be freely available otherwise for the distribution of the dividend.
General Reserve: the reserves that are not created for any specific purpose are known as general reserves. It helps in strengthening the financial position and is also known as a contingency reserve.
Capital Reserve: capital reserves are the reserves that are created from the capital profit and which are not used for distributing the dividend. Such reserves are contaminated and kept for preparing that company for any event that can lead to instability, inflammation, or expanding a business.
