Diminishing Balance Method: Depreciation Simplified

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

1. 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. 

2. This method of calculating depreciation is applicable for valuable assets like buildings, plants and machinery, equipment, etc having a long life.

3. 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.

4. The diminishing balance method of depreciation is acceptable by tax authorities. Hence, it provides tax benefits to the company. 

5. 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

1. It is quite tedious to estimate the appropriate rate of depreciation.

2. The asset value cannot be brought down to zero.

3. As depreciation cost is high initially, it results in lower net income during the initial period.

4. Depreciation is neither based on the asset value nor evenly distributed throughout the useful life of an asset.

5. 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.