Diminishing Balance Method of Depreciation

12/08/2008 21:03

 

Diminishing Balance Method of Depreciation:

Learning Objectives:

  1. Define, explain and give example of the diminishing balance method/written down value method/reducing installment method?

  2. 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.

Journal Entries:

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:

  1. 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.

  2. 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:

  1. This method ignores the question of interest on capital invested in the asset and the replacement of the asset.

  2. This method cannot reduce the book value of an asset to zero if it is desired.

  3. 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.

Example:

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

 

Debit Side

   

Credit Side

 
Date  

$

Date  

$

1994 Jan. 1 To Cash 25,000 1994 Dec. 31 By Depreciation 5,000*
      " By Balance c/d 20,000
   
   
    25,000     25,000
   
   
1995 Jan. 1 To Balance b/d 20,000 1995 Dec. 31 By Depreciation 4,000**
      " By Balance c/d 16,000
   
   
    20,000     20,000
   
   
1996 Jan. 1 To Balance b/d 16,000 1996 Dec. 31 By Depreciation 3,200***
        By Balance c/d 12,800
   
   
    16,000     16,000
   
   

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