Reducing balance depreciation - What is reducing balance depreciation?
Reducing balance depreciation – also known as declining balance depreciation or diminishing balance depreciation – is a method of calculating depreciation whereby an asset is expensed at a set percentage.
Debitoor invoicing software uses straight-line depreciation to help small businesses and freelancers track the value of their assets. Try Debitoor free for 7 days.
The reducing balance method of depreciation results in declining depreciation expenses with each accounting period. In other words, more depreciation is charged at the beginning of an asset’s lifetime and less is charged towards the end.
This can be useful when an asset has higher utility or productivity at the start of its useful life. For example, many types of machinery have higher functionality when they are new, and therefore generate more revenue compared to the later years of their lives. Reducing balance depreciation ensures that depreciation expenses reflect the assets' productivity, functionality, and capacity to generate revenue.
How to calculate reducing balance depreciation
To calculate reducing balance depreciation, you will need to know:
- Asset cost: the original value of the asset plus any additional costs required to get the asset ready for its intended use.
- Residual value: also known as scrap or salvage value, this is the value of the asset once it reaches the end of its useful life.
- Depreciation factor: this correlates to the percentage the asset will depreciate by each year. For example, 2 is 200%, 0.5 is 50%.
Using this information, the reducing balance method calculates depreciation in two steps:
Step 1: Calculate the depreciation charge using the following formula:
Depreciation charge per year = (net book value – residual value) x depreciation factor
Step 2: Subtract the depreciation charge from the current book value to calculate the remaining book value.
These steps should be repeated annually throughout the asset's useful life. In the final year of the asset's useful life, you should subtract the residual value from the current book value and record the amount as an expense.
Bear in mind that this is just one way of calculating residual value. There are a few other calculations and formulas, by this appraoch is one of the most simple, and is therefore suitable for most small businesses and freelancers.
Example of reducing balance depreciation
A company purchases a van for £5,000 The company estimates that the van will lose 40% of its value each year, with a scrap value of £1,000. Following the reducing balance method, the first five years of depreciation calculations would look like this:
Reducing balance depreciation vs. straight-line depreciation
An alternative depreciation method is straight-line depreciation. Whereas the reducing balance method charges depreciation as a percentage of an asset’s book value, the straight-line method expenses the same amount each year.
Unlike the reducing balance method, straight-line depreciation cannot account for higher levels of productivity and functionality at the beginning of an asset’s life. However, for most small businesses, it is sufficient – and much more straight-forward – to use the straight-line method.
Depreciation in Debitoor
With Debitoor invoicing software, depreciation is calculated automatically. Whenever you enter a new expense, you’ll be given the option of marking it as an asset. Simply enter the asset’s useful lifespan and estimated residual value, and let Debitoor do the rest!