REDUCING BALANCE METHOD (or DIMINISHING BALANCE METHOD)

FIRST TERM E-LEARNING NOTE

SUBJECT: FINANCIAL ACCOUNTING 

CLASS: SS 2

WEEK SEVEN AND EIGHT

TOPIC: DEPRECIATION OF FIXED ASSETS

CONTENT                                

• Methods of providing for depreciation

REDUCING BALANCE METHOD (or DIMINISHING BALANCE METHOD)

Under this method, a fixed percentage is written off the reducing (or diminishing) balance of the asset yearly.

This method charges higher depreciation in the early years of the asset and lower in the later   years

The depreciation rate (%) to be applied is computed using the formula below:

S   

Depreciation rate (%)   =    1   –       C

where:

n =    No. of  years

s  =   Scrap value

c  =   Cost

Illustration:

A machine costing N10,000 will realize N256 in four years time. Show the yearly depreciation to be charged for each of the four years using diminishing balance method.

SOLUTION:

S                                                       

Depreciation Rate (%)    =   1   –     C

256

=   1 –     10,000

4

=   1  –    10

=        0.6

=        60%

The depreciation charge applicable to each of the four years will be:

N

Cost                                                           10,000

Year 1       Depreciation = (60% X 10,000)                  6,000

REDUCED BALANCE (i.e. NBV)          4,000

Year 2      Depreciation = (60% X  4,000)                   2,400

REDUCED BALANCE (i.e. NBV)           1,600

Year 3      Depreciation = (60% X 1,600)                       960

REDUCED BALANCE (i.e. NBV)              640

Year 4     Depreciation = (60% X 640)                          348

SCRAP VALUE ( i.e. NBV)                         256

ADVANTAGES OF THE DIMINISHING BALANCE METHOD

1. It is widely used.
2. Depreciation is more scientifically provided for.
3. It recognizes the efficiency of an asset by charging higher amounts in the early years and lower amounts in the later years.
4. Higher depreciation amounts and low maintenance cost in the early years even out with low depreciation amounts and higher maintenance cost in the later years

DISADVANTAGES OF THE DIMINISHING BALANCE METHOD

1. Calculating the rate of depreciation may be difficult
2. It is not ideal for all fixed assets. For example it cannot be used for loose tools.

SUM OF THE YEARS DIGIT

Under this method, the years in the life of the asset are represented with digits and are added. The fraction of the asset cost is then charged to the years in reverse order.

Illustration:

A machine cost N10,000 and has a life span of four years after which it can be sold for N256. Calculate the yearly depreciation charge for each of the four year using the sum of the years digit method.

SOLUTION:

Amount  =  Cost  –  Scrap Value

=  N10,000  –  N256

=   N9,744

No. of years  =  4

Add up the years thus:  1 + 2 + 3 + 4 = 10

i.e. Sum of the four years  =  10

Reverse the digit for each of the year

                                  Year                         Digit

1                                4

2                                3

3                                2

4                                1

Calculation of depreciation charge:

Year 1   =   4    X   9,744           =   N3,898

10

Year 2   =   3     X   9,744          =    N2,923

10

Year 3   =   2     X   9,744          =    N1,949

10

Year 4   =1    X    9,744          =    N974

10

N.B

The sum of the years digit is similar in some respect to the diminishing balance method as it charges higher depreciation in the early years of the asset.

Therefore the advantages and disadvantages of the sum of the years digit are the same as for the Diminishing Balance Method.

EVALUATION QUESTIONS

1. Explain the following methods of depreciation:

(a)  reducing balance method  (b) sum of the years digit

2. Write short notes on the following:

(a)  Depreciation      (b) Salvage value     (c) Obsolescence

REVALUATION METHOD

Under this method the asset is revalued each year, any difference being charged to the profit and loss account.

This method is good for assets which cannot be easily depreciated because of their nature e.g. loose tools (i.e. bolts, nuts, hammer, chisel, screws) livestock, farm crops/plantations e.t.c.The value of the assets at the beginning and end of the year will be estimated and used in the calculation of the depreciation.

Illustration:

On 1^st January 2005, the value of loose tools was N25,000. Purchases of loose tools during the year was N7,000. On 31^st December 2005, the loose tools were revalued at N24,000

Required:  Calculate the depreciation on loose tool for the year.

SOLUTION:

N

Balance of loose tools 1 Jan 2005                     25,000

Add : Purchases of loose tools in 2005               7,000

32,000

Less:  Balance of loose tools 31 Dec 2005        24,000

Depreciation on loose tools for 2005          8,000

ADVANTAGES OF THE REVALUATION METHOD

It is suitable (or ideal ) for loose tools, livestock e.t.c.

DISADVANTAGES OF THE REVALUATION METHOD

1. It cannot be used for all classes of assets.
2. Revaluation of assets on yearly basis may be cumbersome

DEPLETION UNIT METHOD (or PRODUCTION UNIT METHOD )

This method is used for wasting assets such as quarry, mine, timber, and other assets ( like machines) whose useful life can be estimated in hours.

Illustration

A machine costing N100,000 can work for 800 hours. If it works for 120 hours in 2005 and 200hours in 2006. Calculate the depreciation charges for each year.

SOLUTION

Calculation of Depreciation on Machine

2005               120   X  N100,000          =   N15,000

800

2006               200    X  N100,000         =   N25,000

800

EVALUATION QUESTIONS

1. List five methods of providing for depreciation of assets.
2. Mention three characteristics of depreciable assets

GENERAL EVALUATION

• What is depreciation
• Explain the following methods of calculating depreciation (i) staight line  (ii) reducing balance     (iii) sum of the years digit
• What is the difference between depreciation and amortization
• State ten uses of the general journal
• Explain the principle of double entry system

READING ASSIGNMENT

Simplified and Amplified Financial Accounting Page 151 – 167

WEEKEND ASSIGNMENT

A machine cost N12,000 and has a useful life of 4 years and an expected disposal             valueof N400

1. 1. Using the straight line method, the annual depreciation is (a) N3,100 (b) N3,000

(c)N2,900 (c) 2,300

2. 2. The accumulated depreciation at the end of year three using the straight line method

Is (a) N6,900 (b) N8,700 (c) N9,300 (d) N9,600

3. 3. Using the reducing balance method and ignoring residual value, what will be the depreciation charge for year 2 at 20% (a) N3,000 (b) N2,900 (c) N2,400 (d) N1,920
4. 4. Using the reducing balance method and ignoring residual value, what is the net book value at the end of year 2 (a) N10,480 (b) N10,080 (c) N9,680 (d) N7,680

5..        Which of the following is true of the straight line method of depreciation (a) accurate depreciation charges are made yearly (b) the scrap value is zero (c) yearly depreciation charge decreases (d) yearly depreciation charges are constant

THEORY

1. List four advantages enjoyed by a firm that charges depreciation of fixed assets in its final account
2. A motor car cost N51,200. It will be kept for 5 years and then sold at an estimated figure of N12,150. Show the calculations of the figures for depreciation for each year using

(a)  Straight line method

(b)      Reducing balance method at 25% rate of depreciation