What is the Diminishing Balance Method?
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
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.
This method of calculating depreciation is applicable for valuable assets like buildings, plants and machinery, equipment, etc having a long life.
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.
The diminishing balance method of depreciation is acceptable by tax authorities. Hence, it provides tax benefits to the company.
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
It is quite tedious to estimate the appropriate rate of depreciation.
The asset value cannot be brought down to zero.
As depreciation cost is high initially, it results in lower net income during the initial period.
Depreciation is neither based on the asset value nor evenly distributed throughout the useful life of an asset.
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.
FAQs on Diminishing Balance Method: Depreciation Simplified
1. What is the diminishing balance method?
The diminishing balance method is a popular technique used for calculating depreciation on assets. Under this method, depreciation is charged at a fixed percentage of an asset’s book value, which decreases each year. As a result, the depreciation expense is higher in the early years of the asset's life and reduces over time. This method reflects the actual usage and obsolescence of most assets more accurately than some alternatives. The diminishing balance method is often chosen for assets like machinery or vehicles, where the value tends to decline rapidly at first. It helps match the cost allocation to the revenue generated by the asset, especially when its usefulness diminishes over time.
2. How do you calculate diminishing value method?
To calculate depreciation using the diminishing balance method, you apply a fixed depreciation rate to the asset’s book value at the start of each year. This process repeats annually, causing the depreciation amount to decrease as the book value declines. The basic formula used is:
Depreciation Expense = Book Value at Beginning of Year × Depreciation Rate.
The steps typically involved are:
- Determine the asset’s initial cost and the depreciation rate.
- Calculate depreciation by multiplying the current book value by the rate.
- Subtract depreciation from the book value for the next year’s calculation.
3. What is another name for the diminishing balance method?
The diminishing balance method is also known as the reducing balance method or declining balance method. These terms are used interchangeably in accounting literature and practices. The names reflect the core principle of this depreciation technique: the asset’s book value decreases more each year at first, then less in later years due to the constant rate being applied to a shrinking base. Understanding alternate names is useful for accounting research and when reading financial reports from different countries. Regardless of the term used, the calculation mechanics remain the same.
4. What are the 4 methods of calculating depreciation?
There are four main methods used to calculate depreciation, each suitable for different types of assets and business needs. The most common methods are:
- Straight Line Method – Charges an equal amount of depreciation each year.
- Diminishing Balance Method – Uses a fixed percentage on the reducing book value annually.
- Units of Production Method – Depreciation is based on actual usage or production.
- Sum-of-the-Years'-Digits Method – Allocates depreciation in higher amounts in the earlier years.
5. When is the diminishing balance method preferred over the straight line method?
The diminishing balance method is preferred when an asset’s value declines rapidly in the early years or when it delivers higher utility at the start of its useful life. Examples include vehicles, machinery, and technology equipment, which often experience greater wear and tear soon after purchase. Businesses use this method to better match depreciation expenses with the asset's actual usage and declining value over time. This approach provides a more realistic expense allocation, enhancing financial accuracy for high-use or quickly obsolescent assets.
6. What are the advantages of the diminishing balance method?
The diminishing balance method offers several advantages, making it a popular choice for certain types of assets. Its main benefits are:
- Greater depreciation in early years, matching higher asset productivity and wear.
- Better reflects the actual reduction in asset value over time.
- Can provide tax benefits by front-loading expenses.
7. Can the diminishing balance method be used for all types of assets?
The diminishing balance method is not ideal for all asset types. It works best for assets that lose value quickly after being put into use, such as vehicles, computers, or factory machinery. For long-term assets with consistent value, like buildings or furniture, the straight line method may be more suitable. Choosing the right depreciation method depends on asset usage patterns and financial reporting objectives. Applying the diminishing balance method to inappropriate assets could lead to distorted expense reporting.
8. How does the diminishing balance method affect profit and tax calculations?
The diminishing balance method allocates higher depreciation expenses in an asset’s early years, which directly reduces reported profit in those periods. Because depreciation is a non-cash expense, this front-loading effect can also lower taxable income initially, potentially delaying tax payments. Over time, as depreciation charges decrease, reported profits increase. This method, therefore, influences both financial statements and cash flow planning, making it important for businesses focused on short-term tax management or reflecting asset obsolescence accurately.
