Advantages & Disadvantages of Reducing Balance Method

Advantages of Reducing Balance Method of Depreciation (also known as diminishing balance method, written down value method or reducing installment method):

1. Simplicity and Ease of Use

One of the main advantages of the Reducing Balance Method is its simplicity. The method requires only a basic understanding of how to calculate depreciation using the fixed percentage rate applied to the asset's book value. Once the initial cost of the asset and the depreciation rate are determined, it is relatively straightforward to calculate the depreciation expense for each period. This simplicity makes it easy for accountants and businesses to apply this method, particularly when dealing with multiple assets.

Moreover, as the method doesn’t require complex estimations of residual values or changes in useful life, businesses can easily calculate depreciation year over year, providing a clear and consistent framework for accounting. This also simplifies financial reporting and compliance with accounting standards.

2. Acceptance for Income Tax Purposes

The Reducing Balance Method is widely accepted for income tax purposes in many jurisdictions. In some tax systems, businesses are allowed to use this method to claim depreciation on their assets, thus reducing taxable income in the early years of an asset's life. By expensing a higher amount of depreciation upfront, companies can lower their tax liabilities in the short term.

This feature can be particularly advantageous for businesses that need to conserve cash in the initial years of a project or investment. Tax deferral through higher depreciation in the early years can result in immediate cash flow benefits, providing businesses with more capital to reinvest in growth opportunities or cover operational costs.

3. Matching Depreciation with Revenue

A significant advantage of the Reducing Balance Method is its ability to match depreciation with the actual use and revenue generation of the asset. In the early years, when the asset is likely to generate higher revenue due to its newness and greater efficiency, the higher depreciation expense helps offset the higher revenue. This matching principle ensures that the financial statements reflect a more accurate picture of the asset’s contribution to the company’s earnings.

For example, when a company invests in new machinery, the equipment might produce higher output initially, leading to higher revenue. The Reducing Balance Method accounts for this by charging a higher depreciation expense in the early years, which aligns with the asset's higher usage and productivity. This results in a more accurate reflection of the company’s financial performance during the early years of the asset's life.

Disadvantages of the Reducing Balance Method of Depreciation

1. Heavy Depreciation Charge in the Early Years

While the Reducing Balance Method provides higher depreciation in the initial years, this can also be a disadvantage. The higher depreciation charges during the early years may result in the asset’s book value decreasing rapidly, which might not reflect the actual usage or wear and tear of the asset.

In some cases, businesses may prefer to have a more gradual reduction in asset value, especially if the asset is expected to remain in good working condition for an extended period. As the Reducing Balance Method accelerates depreciation, it might create a situation where the asset’s book value falls below its actual market value before the end of its useful life. This rapid depreciation can distort financial statements, especially if the asset continues to generate revenue beyond its depreciated book value.

2. Inability to Reduce Asset Value to Zero

Another significant limitation of the Reducing Balance Method is that, under normal circumstances, it does not allow the asset’s book value to be reduced to zero by the end of its useful life. Since depreciation is calculated based on a fixed percentage of the remaining book value, the depreciation expense continues to decrease over time, but it never fully eliminates the asset’s book value.

This can be a problem if a business wants to fully depreciate the asset by the end of its useful life. In practice, the asset may still have a residual book value even after many years of depreciation. If the company wants to write down the asset to zero, adjustments or a change in depreciation method may be necessary to account for the final years. Additionally, this issue can cause discrepancies in the financial records if the asset is sold or disposed of before its book value reaches zero.

3. Need for a High Depreciation Rate

For the Reducing Balance Method to be effective, a sufficiently high depreciation rate is necessary. If the depreciation rate is too low, it will take a long time to reduce the asset’s book value to its residual value. This could result in a situation where the asset is still generating depreciation expenses long after it has lost its useful value in practical terms.

This is particularly problematic if the asset is expected to generate significant revenue in its later years. If the depreciation rate is set too low, the business may not be able to match depreciation expenses with revenue in the later stages of the asset’s life. Conversely, setting a high depreciation rate can lead to the earlier problem of excessive depreciation charges in the first few years, potentially distorting the financial results.

Conclusion:

In conclusion, the Reducing Balance Method is best suited for businesses that expect high utility from their assets in the initial years and can benefit from accelerated tax deductions. However, companies should be mindful of its limitations, particularly with respect to asset book value and the potential for heavy depreciation in the early years, and should carefully evaluate whether this method aligns with their financial goals and asset management strategy.