Depreciation – Reducing Balance Method

Last Updated
July 28, 2010

The Reducing Balance Method

Note: This method will require the basic functions of a scientific calculator. Alternatively, if you are a wiz at using Microsoft Excel, calculations can be made using this software.

Slightly more complicated than the straight-line method, the reducing balance assumes that an asset loses more value during the earlier years of its life. Consequently, a depreciation rate (%) for reducing value is used, resulting in less value being lost each year.

Using the same example as before, a car is purchased at £16,000, with a residual value of £4,000 to be used for four years.

Now, there are two formulas that need to be considered here (nothing too extreme). Firstly, you need to work out the depreciation rate using the formula below. If you are unsure of the asset lifetime (in, say, years), then the following formula can be ignored. Instead, you would have to estimate a reasonable depreciation rate that compliments the particular asset. (where n is the expected lifetime in years)

Therefore:

The depreciation can now be worked out as follows:

Year Depreciation Net Book Value
0 0 £16,000
1 £4800 (£16,000 x 30%) £11,200
2 £3360 (£11,200 x 30%) £7840
3 £2352 (£7840 x 30%) £5488
4 £1646 (£5488 x 30%) £3842

The residual value of £3842 is not exactly the £4000 that was suggested. The calculations would have arrived at this figure in the fourth year if we used the exact depreciation rate instead of rounding up to a whole number, in this case – 30% and not 29.2893…%.

Summary

Having the fundamental knowledge of business accounting is almost a pre-requisite of running a successful business. Whether this is achieved through your bookkeeper or your accountant, the small business owner needs to understand the pros and cons of using different methods for, say, purchasing/tax-efficiency, and as a result, make best use of the cash flow generated by the business. For those small business owners that choose to compile their own business accounts, it is important that you have some understanding of depreciation. By acknowledging depreciation in the accounts, it will result in a more accurate statement that reflects the business’ financial position. As depreciation accumulates, it will result in your business having reduced profits although the effect may not be too significant. Consequently, it can give you an idea of when you need to replace a particular asset and to aid in How & Why to Price Your Products Successfully to cover expenses. Depreciation is recorded on both the balance sheet and profit and loss accounts shown differently on each statement. Calculating depreciation is a simple task, although some estimation is required that will results in figures not being 100 per cent accurate. This is true for all cases and is something that we have to accept, although with time, it is possible to reduce this amount of inaccuracy by comparing past experiences of life expectancies and residual values.

Relevant Articles

Article Index

  1. Depreciation - What Does it Mean
  2. Reducing Balance Method
Related Articles
Popular Articles in Accountancy