DEPRECIATION Reducing Balance Method & Production based method

Depreciation
Depreciation is a systematic and rational process of distributing the cost of tangible assets over the life of assets.

Depreciation is a process of allocation. Cost to be allocated = acquisition cost - salvage value Allocated over the estimated useful life of assets.

Allocation method should be systematic and rational.

Depreciation Methods
(A) Straight Line Method (B) Reducing Balance Method/Diminishing Balance Method (C) Revaluation Method (D) Sum of Digits Method/Sum of The Years Digits Method (E) Production Output Method/Units of Production Method

Reducing balance method

Also called as Diminishing balance method or percentage on book value method In many cases ,the cost of maintenance of an equipment i.e. the fixed asset increases towards the end of its life

Desirable to calculate depreciation so that charge lessens towards end

Reducing balance method

Let x be the fixed percentage taken to calculate the yearly depreciation on the book value then

where C=initial cost S=scrap value n=no. of years of life

Reducing Balance Method

Question A lathe machine is purchased for Rs.8000 and the assumed life is 10 years and scrap value is Rs.2000 .If the depreciation is charged by reducing balance method , calculate the percentage by which value of the lathe machine is reducing every year and depreciation fund after 2 years. Solution Here C=Rs.8000 S=Rs.2000 n=10 years we know that

 Substituting in the equation

x=(1-0.8706) =.1294 Required percentage=12.94%

Value of lathe after 1 year = 8000(1-.1294)=Rs.6964.80 Therefore depreciation fund after 1 year=Rs.(8000-6964.80) =Rs.1035.20 New value of lathe after 2nd year = 6964.80(1-.1294)=Rs.6063.55 Depreciation of 2nd year =Rs.(6964.80-6063.55) =Rs.901.25 Depreciation fund after 2nd year = Rs.(1035.20+901.25) =Rs.1936.45

Advantages of reducing balance method

it is simpler to understand It is realistic because the maintenance cost increases towards the end of a products life It provides a good mathematical relation for calculating the depreciation

Disadvantages of reducing balance method

It is not simple to fix the percentage

Standard percentage for all conditions may produce misleading results

Units of production method

The units of production method deals with items that deteriorate more with use rather than age In this case, the effective life is determined by total output rather than age Examples of items for which this method may well be appropriate include

tyres on a vehicle machine parts cutting blades photocopiers printers or any items in continuous use

Units-of-Production Method

The ride has a 100,000-mile estimated useful life. If the ride is used 30,000 miles in the first year, what is the amount of depreciation expense? 30,000 100,000

($62,500 - $2,500)

$18,000

9-12

Units-of-Production Method
Depreciation Depreciation Expense Expense (debit) $ 18,000 30,000 12,000 60,000 Accumulated Depreciation (credit balance) Balance $ 18,000 48,000 60,000 Undepreciated Balance (book value) $ 62,500 44,500 14,500 2,500

Year 1 2 3

Miles 30,000 50,000 20,000 100,000

9-13

Use of Depreciation Methods

Declining4% Balance

Other Units-of-Production
8% 5%

83%

Straight-Line
Source: Accounting Trends & Techniques, 56th. ed., American Institute of Certified Public Accountants, New York, 2002.

Advantages of production based method

A far more accurate estimate of depreciation cost
Provides a far better picture of the true costs;also help assess the true state of each asset owned by the firm.

Disadvantages of production based method

The major shortcoming of the units of production method is that it is hard to apply to real-life situations. Even when an asset depreciates only with use, it is often not easy to estimate how many units can be manufactured with a particular piece of machinery before it will have to be salvaged

Thank you..