Definition
Diminishing-Balance Method (Reducing-Balance Method) refers to a method of computing the depreciation of a fixed asset in an accounting period. In this method, the depreciation percentage is applied to the asset’s net book value (the depreciated value at the beginning of the period). This approach leads to a higher depreciation charge in the earlier years and gradually reduces the annual depreciation charge over time. The formula to determine the annual percentage can be given as:
\[ \text{Annual Depreciation Percentage} = \frac{1 - \sqrt[N]{\frac{S}{C}}}{1} \]
Where:
- N is the estimated life in years,
- S is the estimated scrap value at the end of its useful life, and
- C is the original cost.
Examples
Example 1: Machinery Depreciation
A company purchases machinery for $50,000 expected to last for 10 years with a scrap value of $5,000. Using the diminishing-balance method, the annual depreciation percentage is calculated. For this machinery, by applying the formula, this results in a higher depreciation charge in the earlier years and a gradually decreasing charge in later years.
Example 2: Vehicle Depreciation
A business buys a delivery vehicle for $30,000, with an estimated useful life of 5 years and a scrap value of $3,000. Using the diminishing-balance method, they calculate the annual depreciation, which declines over the 5-year period, reflecting the reducing balance approach.
Frequently Asked Questions (FAQ)
1. How does the diminishing-balance method differ from the straight-line method?
The diminishing-balance method calculates depreciation based on a fixed percentage of the asset’s beginning balance each year, leading to a higher depreciation rate initially. In contrast, the straight-line method evenly distributes depreciation expense over the useful life of the asset.
2. What are the advantages of the diminishing-balance method?
The diminishing-balance method better matches the depreciation expense with the actual wear and tear of the asset, resulting in a higher expense when the asset is more productive.
3. Can all assets be depreciated using the diminishing-balance method?
Not all assets suit the diminishing-balance method. It is more commonly used for assets that lose value rapidly initially but still retain some residual value.
4. How is the annual percentage rate determined in the diminishing-balance method?
The annual percentage rate is derived using the formula mentioned above, considering the asset’s original cost, its estimated useful life, and the scrap value.
5. Why would a company elect to use the diminishing-balance method?
A company might choose the diminishing-balance method to reflect a higher depreciation expense when the asset is new and being used intensely, which might align with business performance and the actual reduction in value more accurately.
- Depreciation: The systematic allocation of the cost of a tangible asset over its useful life.
- Fixed Asset: A long-term tangible piece of property or equipment that a firm owns and uses in its operations to generate income.
- Net Book Value: The value of an asset after accounting for depreciation or amortization.
Online References
Suggested Books for Further Studies
- Intermediate Accounting by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
- Financial Accounting by Walter T. Harrison Jr., Charles T. Horngren, C. William (Bill) Thomas
- Accounting Made Simple by Mike Piper
Accounting Basics: “Diminishing-Balance Method” Fundamentals Quiz
### What is the primary characteristic of the diminishing-balance method of depreciation?
- [ ] Depreciation is evenly spread over the asset's useful life.
- [x] Depreciation is higher in the earlier years and decreases over time.
- [ ] Depreciation remains constant throughout.
- [ ] Depreciation starts low and increases over time.
> **Explanation:** The diminishing-balance method results in a higher depreciation charge during the earlier years and gradually reduces over time as the asset's value decreases.
### How is the annual depreciation expense calculated in the diminishing-balance method?
- [ ] Based on a fixed dollar amount.
- [x] Using a fixed percentage of the depreciated value at the beginning of each period.
- [ ] Only considering the asset's scrap value.
- [ ] By dividing the asset's cost by the number of years.
> **Explanation:** The annual depreciation expense in the diminishing-balance method is calculated using a fixed percentage of the asset's depreciated value at the start of each accounting period.
### For which type of assets is the diminishing-balance method most appropriate?
- [ ] Assets that do not depreciate quickly.
- [ ] Assets with indefinite useful lives.
- [ ] Financial investments.
- [x] Assets that lose value rapidly in the initial years.
> **Explanation:** The diminishing-balance method is ideal for assets that typically lose their value rapidly within the first few years following acquisition, accurately reflecting the high initial depreciation.
### What is the formula used to determine the annual depreciation percentage in the diminishing-balance method?
- [ ] \\((C \times N) - S\\)
- [ ] \\((C - S) \div N\\)
- [ ] \\(\frac{S}{C}\\)
- [x] \\(1 - \sqrt[N]{\frac{S}{C}}\\)
> **Explanation:** The formula to find the annual depreciation percentage is \\(1 - \sqrt[N]{\frac{S}{C}}\\), considering the asset's original cost (C), its scrap value (S), and estimated useful life (N).
### Which term represents the remaining value of the asset after accounting for depreciation?
- [x] Net Book Value
- [ ] Gross Value
- [ ] Original Cost
- [ ] Residual Cost
> **Explanation:** The net book value represents the remaining value of an asset after reducing it by accumulated depreciation.
### How does diminishing-balance depreciation impact profits over time?
- [ ] Increases profits steadily.
- [x] Decreases depreciation charges and increases profits gradually.
- [ ] Keeps profits unchanged.
- [ ] Consistently lowers profits.
> **Explanation:** The diminishing-balance method decreases depreciation charges over time, which in effect leads to gradually increasing profits.
### Can the diminishing-balance method be used for tax purposes in all jurisdictions?
- [ ] Yes, in all countries.
- [ ] No, it is universally prohibited.
- [x] It depends on specific jurisdictional regulations.
- [ ] Only for personal assets.
> **Explanation:** The use of the diminishing-balance method for tax purposes depends on specific regulations in different jurisdictions. Businesses must confirm the allowable methods in their country or region.
### Which of the following is affected most by the diminishing-balance method in the initial years?
- [x] Depreciation expense
- [ ] Salvage value
- [ ] Inflation rate
- [ ] Market risk
> **Explanation:** In the initial years, the depreciation expense is most affected under the diminishing-balance method as it results in higher depreciation charges early on.
### Which accounting length (lifespan of an asset) most benefits from the diminishing-balance method of depreciation?
- [ ] Short-term (1 to 2 years)
- [x] Long-term (5 to 10 years or more)
- [ ] Mid-term (3 to 5 years)
- [ ] Any length of time equally
> **Explanation:** The diminishing-balance method is most beneficial for long-term assets that require accounting for quicker value reduction initially, thus aligning depreciation with asset usage and wear.
### Over time, how does the diminishing-balance method align with an asset's productivity?
- [x] Matches higher initial depreciation with higher initial productivity.
- [ ] Increases depreciation when productivity decreases.
- [ ] Does not relate to productivity.
- [ ] Decreases productivity over time.
> **Explanation:** The diminishing-balance method aligns higher initial depreciation with the asset's higher initial productivity, thus better reflecting the usage and economic benefits derived from the asset.
Thank you for exploring the fundamentals of the diminishing-balance method. Continue advancing your accounting knowledge with practical scenarios and quizzes!
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