Depreciation is spreading the cost of any asset over its useful lifetime. The asset's value is bound to decrease over time because of usage, wear and tear, technological advancements that make better assets available, and simple aging. Depreciation is carried out on the simple premise that a portion of the asset is used during a specified time period and will never again be recovered, whether by disposal or resale or the asset. Although depreciation is a non-cash expense--that is, it does not directly affect the cash flows of the organization--its expense is accounted for in each financial period. The reducing balance method is one of several types of depreciation methods.
Types of Depreciation Methods
Depreciation can be computed using several methods. The general principles are based on time or on use of the asset. Companies generally use the straight line method, the reducing balance method, the sum of years method, the units of time method or the group depreciation method. Each has different uses and benefits. The reducing balance method is frequently used for electronic assets, which are subject to technological advancements and can become obsolete very quickly.
What Is the Reducing Balance Method?
Under the reducing balance method, the cost of the asset is depreciated at a constant rate each year. This method is based on the premise that an asset is more useful in its initial years than in its later years. So, instead of spreading the total cost of the asset over its productive lifespan, it is expensed at a constant rate.
The annual depreciation is calculated as the depreciation rate multiplied by the book value of the asset at the beginning of the year. For example, if the asset's cost when it was bought was $5,000, and the rate of depreciation is 40% annually, the depreciation at the end of the first year would be $2,000 and the book value at the end of the year would be $3,000. At the end of the second year, that year's depreciation would be $1,200 and the book value of the asset would be $1,800: $3,000 (book value at the beginning of the year) minus $1,200 (this year's depreciation). The accumulated depreciation at the end of the second year is $3,200: $2,000 + $1,200.
By the reducing balance method, depreciation is accelerated so that in the early years, a large portion of the asset is written off. The burden in later years is thus reduced. This actually a wise thing to do as the value of the asset diminishes with the passage of time. The asset may rot or may be subject to wear and tear, and newer and far superior products may be available in the market. In that scenario, if the business assumes a greater value and price for this asset and on sale actually realizes much less than that, it has to face a loss. But, if the business writes off a large portion and realizes a greater price on sale, it stands to make a profit.
Flaw of this Method
There is only one visible flaw in this method. The reducing balance method never takes into account the scrap value of the asset. The asset is always written off during its productive lifespan.