Diminishing Balance Method of Depreciation
Diminishing Balance Method of Depreciation:
Define, explain and give example of the diminishing balance method/written down value method/reducing installment method?
What are advantages and disadvantages of diminishing balance method?
Definition and Explanation:
Diminishing balance method is also known as written down value method or reducing installment method. Under this method the asset is depreciated at fixed percentage calculated on the debit balance of the asset which is diminished year after year on account of depreciation.
The entries in this case will be identical to those discussed in the case of the fixed installment method. Only the amount will be differently calculated.
Advantages of Diminishing Balance Method:
The strongest point in favor of this method is that under it the total burden imposed on profit an loss account due to depreciation and repairs remains more or less equal year after year since the amount after depreciation goes on diminishing with the passage of time whereas the amount of repairs goes on increasing an asset grow older.
Separate calculations are unnecessary for additions and extensions, though in the first year some complications usually arise on account of the fact that additions are generally made in the middle of the year.
Disadvantages of Diminishing Balance method:
This method ignores the question of interest on capital invested in the asset and the replacement of the asset.
This method cannot reduce the book value of an asset to zero if it is desired.
Very high rate of depreciation would have to be adopted other wise it will take a very long time to write an asset down to its residual value
Scope of Application:
Diminishing balance method of depreciation is most suited to plant and machinery where additions and extensions take place so often and where the question of repairs is also very important. Written down value method or reducing installment method does not suit the case of lease, whose value has to be reduced to zero.
On 1st January, 1994, a merchant purchased plant and machinery costing $25,000. It has been decided to depreciate it at the rate if 20 percent p.a. on the diminishing balance method (written down value method). Show the plant and machinery account in the first three years.
Plant and Machinery Account
|1994 Jan. 1||To Cash||25,000||1994 Dec. 31||By Depreciation||5,000*|
|"||By Balance c/d||20,000|
|1995 Jan. 1||To Balance b/d||20,000||1995 Dec. 31||By Depreciation||4,000**|
|"||By Balance c/d||16,000|
|1996 Jan. 1||To Balance b/d||16,000||1996 Dec. 31||By Depreciation||3,200***|
|By Balance c/d||12,800|
Formula or equation for the depreciation calculation may be written as follows:
*First year: 25,000 × 20% = 5000
**Second Year: (25000 - 5000) × 20% = 4,000
***Third Year: [25000 - (5,000 + 4,000)] × 20% = 3,200