Reducing Balance Method: Definition
Under the reducing balance method, the amount of depreciation is calculated by applying a fixed percentage on the book value of the asset each year.
In this way, the amount of depreciation each year is less than the amount provided for in the previous year. This is because the book value used to compute the depreciation expense is continually reduced from year to year.
Reducing Balance Method: Formula
Use the following formula to calculate depreciation under the reducing balance method:
Depreciation = Asset book value x Depreciation rate
Depreciation is the dollar amount lost in value
Asset book value is the value of the asset for accounting purposes
Depreciation rate is the percentage decline in the asset’s value
Example: Calculating Depreciation Under Reducing Balance Method
On 1 January 2016, XYZ Limited purchased a truck for $75,000. Depreciation is estimated at 20% per year on the book value.
Required: Calculate the truck’s depreciation for 2016, 2017, and 2018.
The book value at the beginning of 2016 is $75,000. Depreciation for 2016 is $75,000 × 0.2 = $15,000.
The book value at the beginning of 2017 is $75,000 – $15,000 = $60,000. Depreciation for 2017 is $60,000 × 0.2 = $12,000.
The book value at the beginning of 2018 is $60,000 – $12,000 = $48,000. Depreciation for 2018 is $48,000 × 0.2 = $9,600.
Notice that the depreciation provided in 2018 ($9,600) is less than the amount of depreciation provided in 2017 ($12,000). In turn, this is less than the amount provided in 2016 ($15,000).
The reason for this is that the rate of depreciation (20% in this case) is being applied to the book value, which continually reduces each year.
In 2016, the book value was $75,000, while in 2017, it fell to $60,000. A year later, it reduced to $48,000. Remember that the rate of depreciation remains constant but it is applied to a lesser amount (i.e., book value) each year.
Hence, the amount of depreciation each year is lower.
The reducing balance method is also known as the reducing installment method. It is especially useful for fixed assets whose value deteriorates faster in the earlier years of usage (e.g., cars, office equipment, and small machinery).