Diminishing balance method

3 key takeaways

• The diminishing balance method accelerates depreciation, resulting in higher depreciation expenses in the early years and lower expenses in later years.
• This method is suitable for assets that lose value more quickly in their early years, such as vehicles, machinery, and technology.
• The diminishing balance method reflects the usage pattern of certain assets more accurately than the straight-line method, which spreads depreciation evenly.

What is the diminishing balance method?

The diminishing balance method, also known as the declining balance method or reducing balance method, is a technique for calculating depreciation where a constant depreciation rate is applied to the asset’s book value each year. The book value of the asset decreases annually as depreciation is subtracted, resulting in decreasing depreciation expenses over time. This method is often used for assets that have a higher utility and therefore lose value more rapidly in the initial years of their life.

How the diminishing balance method works

• Depreciation Rate: A fixed percentage rate is determined based on the asset’s useful life and the company’s depreciation policy. This rate is applied to the asset’s book value at the beginning of each year.
• Book Value: The book value is the asset’s cost minus accumulated depreciation. At the start, the book value is the asset’s original cost. Each year, the depreciation expense is subtracted from the book value to get the new book value for the next year.
• Depreciation Expense Calculation: The depreciation expense for each year is calculated by multiplying the fixed depreciation rate by the current book value of the asset.

Formula for the diminishing balance method

The formula for calculating the annual depreciation expense using the diminishing balance method is:

[ \text{Depreciation Expense} = \text{Depreciation Rate} \times \text{Book Value at Beginning of Year} ]

Example of the diminishing balance method

Assume a company purchases machinery for $10,000 with an estimated useful life of 5 years and decides to use a depreciation rate of 40%. Here’s how the depreciation expense and book value are calculated for each year:

Year 1:

• Book Value: $10,000
• Depreciation Expense: $10,000 (\times) 40% = $4,000
• Book Value at End of Year: $10,000 – $4,000 = $6,000

Year 2:

• Book Value: $6,000
• Depreciation Expense: $6,000 (\times) 40% = $2,400
• Book Value at End of Year: $6,000 – $2,400 = $3,600

Year 3:

• Book Value: $3,600
• Depreciation Expense: $3,600 (\times) 40% = $1,440
• Book Value at End of Year: $3,600 – $1,440 = $2,160

Year 4:

• Book Value: $2,160
• Depreciation Expense: $2,160 (\times) 40% = $864
• Book Value at End of Year: $2,160 – $864 = $1,296

Year 5:

• Book Value: $1,296
• Depreciation Expense: $1,296 (\times) 40% = $518.40
• Book Value at End of Year: $1,296 – $518.40 = $777.60

Benefits of the diminishing balance method

• Reflects Actual Usage: It better matches the expense with the revenue generated by the asset, as many assets provide more utility and face higher wear and tear in the early years.
• Tax Advantages: Higher depreciation expenses in the early years can lead to tax savings by reducing taxable income more significantly in the initial periods.

Limitations of the diminishing balance method

• Complex Calculations: It requires more complex calculations compared to the straight-line method, which might be burdensome for some businesses.
• Lower Depreciation Later: The method results in lower depreciation expenses in the later years, which might not reflect the actual wear and tear of certain assets over time.

Applications

The diminishing balance method is widely used for:

• Vehicles: Given their rapid decline in value.
• Machinery and Equipment: Especially in manufacturing, where heavy use leads to faster initial depreciation.
• Technology: Such as computers and software, which quickly become obsolete.

Related topics

For further reading, consider exploring the following topics:

• Straight-Line Depreciation: A simpler method that spreads the cost of an asset evenly over its useful life.
• Double Declining Balance Method: A more accelerated form of the diminishing balance method, applying twice the straight-line depreciation rate.
• Depreciation: General concepts and various methods used to allocate the cost of tangible assets over their useful lives.
• Amortization: The process of spreading the cost of intangible assets over their useful life.

Understanding the diminishing balance method is crucial for accurately calculating depreciation expenses, managing financial statements, and making informed decisions about asset management and tax planning.