Reducing Balance Method of Depreciation

What is the Reducing Balance Method of Depreciation?

The reducing balance method is a form of accelerated depreciation. It calculates depreciation by applying a fixed percentage to the net book value of the asset at the beginning of each accounting period, rather than applying a fixed amount of depreciation each year. This means that the depreciation expense decreases as the asset’s book value decreases over time.

Under this method, the depreciation expense for each year is determined by multiplying the asset’s current book value (after subtracting accumulated depreciation) by a fixed percentage rate, often referred to as the depreciation rate. The percentage remains constant throughout the asset’s life, but because the asset's book value decreases with each period’s depreciation, the annual depreciation expense also decreases over time.

Advantages of the Reducing Balance Method

1. Higher Depreciation in Early Years One of the primary advantages of the reducing balance method is that it provides higher depreciation charges in the earlier years of an asset’s life. This can be particularly useful for businesses that expect their assets to lose value more quickly in the beginning. Many assets, such as vehicles, machinery, or technology, experience rapid wear and tear in their initial years of use, making this method more reflective of the actual depreciation patterns.

2. By allocating more depreciation expense upfront, the reducing balance method helps businesses recover costs faster and potentially reduce their tax liabilities in the early years of asset ownership.

3. More Accurate Reflection of Asset Usage The reducing balance method better matches the actual usage and wear and tear of an asset. In industries where assets are heavily utilized early in their useful life and experience less usage later on, this method mirrors the asset's actual depreciation more accurately. For instance, machinery or vehicles often incur higher maintenance and repair costs in the early years, followed by declining repair needs as they age. The reducing balance method aligns depreciation expense with this pattern.

4. Tax Benefits Because the reducing balance method results in higher depreciation in the earlier years, businesses can use it to reduce taxable income in the short term. The higher depreciation charges lead to lower profits, which reduces the business’s tax burden. This can be particularly beneficial for businesses looking to maximize their tax deductions in the early years of asset ownership.

5. Cash Flow Improvement The reducing balance method can improve a company’s cash flow in the short term. Since the method accelerates depreciation, businesses pay less in taxes due to the higher depreciation expense. The savings on taxes can then be reinvested into the business, improving liquidity during the early stages of asset use when capital expenditures might be high.

6. Suitability for Long-Term Assets This method is particularly suitable for assets that provide greater value in their early years of use. For instance, high-value machinery and technology often experience rapid depreciation due to technological obsolescence or intensive early use. The reducing balance method accounts for this by providing greater depreciation early on, reflecting the asset’s actual loss of value.

Disadvantages of the Reducing Balance Method

1. Decreasing Depreciation Charges Over Time While the higher depreciation in the early years can be an advantage for tax purposes and cash flow, it also has its downsides. As depreciation charges decrease in the later years of the asset’s life, businesses may find that their depreciation expense is too low in the later years. This means that the asset may not be fully depreciated by the time it is no longer in use or when it is sold.

2. For some businesses, the declining depreciation can lead to a mismatch between the depreciation expense and the asset’s actual maintenance or operational costs, which may remain higher in the later years.

3. Complexity in Accounting The reducing balance method requires more frequent recalculations than the straight-line method because depreciation is calculated based on the asset's book value at the start of each year. This means that businesses must keep track of the asset’s accumulated depreciation and adjust calculations annually, which can be time-consuming and complex, especially when managing a large number of assets.

4. Potential for Over-Depreciation in the Early Years The higher depreciation charges in the initial years can sometimes result in over-depreciation, especially if the asset is still functional and contributing to the business’s operations. While accelerated depreciation helps businesses reduce their tax liabilities in the short term, it may also create a situation where the asset is written off too quickly compared to its actual usable life.

5. Asset’s Residual Value Consideration The method can lead to complications in calculating an asset’s residual value or salvage value. If an asset is over-depreciated in the early years, it may not have sufficient value left to recover at the end of its useful life. This can be an issue if the business wishes to sell or trade the asset at a later date.

6. Not Suitable for All Types of Assets The reducing balance method is not always appropriate for all assets. It is primarily used for tangible assets that lose value more rapidly in the initial years of use. For assets that have a more predictable, even rate of depreciation over time, such as real estate or buildings, the straight-line method may be more suitable. The reducing balance method would not reflect the asset’s consistent value in such cases, leading to inaccurate financial statements.

Formula:
Depreciation charge = net book value x rate of depreciation

Example:
Cost of vehicle = $20,000
Estimated useful life = 4 years
Expected disposal value at the end of useful life = $1,250
Depreciation rate = 50%
Calculate the annual depreciation for the next four years.

Answer:
Depreciation (year 1) = $10,000
Depreciation (year 2) = (20000-10000)x50% = $5,000
Depreciation (year 3) = (20000-15000)x50% = $2,500
Depreciation (year 4) = (20000-17500)x50% = $1,250