Reducing Balance Method 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
An asset has a useful life of 3 years.
Cost of the asset is $2,000.
Residual Value is $500.
Rate of depreciation is 50%.
Depreciation expense for the three years will be as follows:
| Year | NBV | R.V | Rate | Depreciation | Accumulated Depreciation | |||
|---|---|---|---|---|---|---|---|---|
|
Year 1 |
(2000 |
- |
500) |
x |
50% |
= |
750 |
750 |
|
Year 2 |
(1250 |
- |
500) |
x |
50% |
= |
375 |
1,125 |
|
Year 3 |
(875 |
- |
500) |
x |
50% |
= |
375* |
1500 |
*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.
Quiz
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Question
Which of the following is true regarding Reducing Balance Method of depreciation?
It results in higher reported profits in the early years of an asset's life.
Incorrect.
Reducing balance method causes reported profits of a company to decline by a higher depreciation charge in the early years of an assets life.
It is a more suitable method for depreciating assets that generate higher economic benefits later in their useful life.
Incorrect.
As under reducing balance method assets are depreciated at a faster rate in the early stage of their useful life, it is a more suitable method for assets that have greater utility in the earlier years. A better method for depreciating assets whose utility progressively increases is the Sum of the Digits Method.
It must be applied where an asset is expected to face technological obsolescence relatively quickly.
Correct.
Assets that face a relatively high risk of technological obsolescence progressively decrease the competitive advantage a company can gain from their use. The depreciation method used should therefore charge a higher portion of the cost of such assets in the earlier years which is why reducing balance method is most appropriate.