What is reducing balance depreciation?
Reducing balance depreciation is a method of calculating depreciation whereby an asset is expensed at a set percentage.
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The reducing balance method of depreciation results in declining depreciation expenses with each accounting period. In other words, more depreciation is charged at the beginning of an asset’s lifetime and less is charged towards the end. Reducing balance depreciation is also known as declining balance depreciation or diminishing balance depreciation.
To calculate reducing balance depreciation, you will need to know the:
Asset cost: the original value of the asset plus any additional costs required to get the asset ready for its intended use.
Residual value: also known as scrap or salvage value, this is the value of the asset once it reaches the end of its useful life.
Depreciation factor: correlates to the percentage the asset will depreciate by each year. For example, 2 is 200%, 0.5 is 50%.
Using this information, the reducing balance method calculates depreciation in two steps:
Step 1: Calculate the depreciation charge using the following formula:
Depreciation charge per year = (net book value – residual value) x depreciation factor
Step 2: Subtract the depreciation charge from the current book value to calculate the remaining book value.
These steps should be repeated annually 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 as an expense.
Bear in mind that this is just one way of calculating residual value. There are a few other calculations and formulas, but this approach is one of the most simple and is therefore suitable for most small businesses and freelancers.
There are several different ways of calculating depreciation, and one of the most commonly used depreciation methods is straight-line depreciation.
The main similarity between the reducing balance and straight-line methods of depreciation is that they are based on time rather than usage. This means that both depreciation methods consider the value of an asset to decline over time and do not consider how much an asset is actually used.
The main difference between the reducing balance and straight-line methods of depreciation is that while the reducing balance method charges depreciation as a percentage of an asset’s book value, the straight-line method expenses the same amount each year.
The reducing balance method of depreciation is most useful when an asset has higher utility or productivity at the start of its useful life, as it results in depreciation expenses that reflect the assets' productivity, functionality, and capacity to generate revenue.
For example, many types of machinery have higher functionality when they’re new and therefore generate more revenue in the earlier years of their lives. The reducing balance method of depreciation reflects this more accurately than other depreciation methods.
On the other hand, straight-line depreciation results in equal depreciation expenses and therefore cannot account for higher levels of productivity and functionality at the beginning of an asset’s useful life. Nonetheless, the straight-line method is much easier to calculate, and might therefore be a more suitable option for freelancers or small business owners who manage their own finances.
A company purchases a van for £5,000. The company estimates that the van will lose 40% of its value each year and will have a scrap value of £1,000. Following the reducing balance method, the first five years of depreciation calculations would look like this:
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