Depreciation is the process of allocation of cost of an asset over its estimated useful life. This allocation is done by means of charging depreciation on the value of the Asset and matching the same against the revenues of that particular period. The yearly amount of depreciation which is charged to the profit and loss account is nothing but the capital expenditure, which was spent on the acquisition of the Asset, being allocated to that specific accounting period within the working life of the Asset.
There are many methods of calculating the amount of depreciation to be charged every year. We have already discussed the Straight Line method or Fixed Installment method of depreciation. In this article we will specifically focus on the Written Down value or the Reducing Balance method of depreciation.
Written Down value or the Reducing Balance method of depreciation
Written down value or the reducing balance method of depreciation is a method in which depreciation is calculated at a fixed percentage on the original cost in the first year. However in the subsequent years, depreciation is calculated at the same fixed percentage not on the original cost but on the written down values gradually reducing during the expected working life of the Asset due to charge of depreciation.
The rate of depreciation is a fixed percentage but in this case the amount allocated every year gradually decreases. The whole thing may sound a bit confusing but let me clear your doubts by an example below.
Before starting with the example I would like to clarify that under this method the annual depreciation is always a fixed rate on the written down value of the asset brought forward from the previous year.
In order to make the example a bit easy to understand we will continue with the same figures that we used in the example to calculate the straight line method of depreciation.
A machine was purchased for Rupees 1,00,000, the estimated useful life of which is 8 years. The eatimated salvage value of the machine at the end of its useful life is Rs. 20,000. It was decided to charge depreciation at 10% every year on the written down value of the machine.
The results under the written down value method after charging depreciation for 8 years will be as shown in the table below:
*WDV = Written Down Value
|Year||Cost/WDV||Depreciation @ 10% on WDV||Net Book Value (at the end of the year)|
In the example we discussed in the straight line methods of depreciation we had seen that, at the end of the 8th year, using the straight line method, only Rs. 20,000 (that is the Salvage value) was left to be written off. However in the present scenario when we are using the written down value method of depreciation, the net book value of the Asset at the end of the 8th year is Rs. 43,047. There is still an amount of Rupees (43047 – 20000) = 23047 left to be written off.
Hence a higher percentage rate is needed to reduce the Asset to its disposable value in a given time under the written down value method. This is because the fixed rate of depreciation is applied to the written down value or the diminishing balance of the Asset instead of the original cost of asset as it was done in the straight line method of depreciation. It is for the same reason that the diminishing balance method or the written down value method will never reduce an asset to zero net book value.
In a scenario where the estimated life of the Asset and the residual value of the asset can be reasonably estimated, the rate of depreciation may be calculated by the following formula:
where n = estimated life of the asset in years.
Assumptions of the Written Down Value/ Reducing Balance Method of Depreciation
The written down value or the diminishing balance method of depreciation is based on the following assumptions:
- The service potential of an asset gradually reduces with the passage of time.
- As an asset becomes old the cost of repairs and maintenance related to that asset gradually increases.
The written down value method of depreciation can be applied for an asset requiring more repairs in later years and whos working life cannot be reasonably estimated. For example Plant and Machinery, Buildings etc.
Let us discuss some advantages of the written down value method of depreciation.
Advantages of the written down value method of depreciation:
- This method is simple to understand and easy to operate. A separate calculation need not be made in respect of every addition to the main asset.
- The amount of annual depreciation reduces with the reducing balance of the asset.
- The amount of depreciation is higher in the earlier years when the machine is efficient and the cost of repairs is low. In later years amount of depreciation becomes lower and the amount of repairs increase due to extended use and wear & tear of the Asset. Thus the total charge for depreciation and repairs together remains more or less uniform over the years. This helps in eliminating huge variations in annual profits or losses.
- This method takes care of the obsolescence problem related to the assets as the major part of depreciation is charged in the earlier years. Due to this feature replacement of the assets before the end of its estimated useful life becomes easy and feasible.
- This method is recognised by tax authorities and other legal bodies.
In spite of having so many advantages this method is not free from demerits. Below we will see some of the demerits of the written down value method of depreciation.
Disadvantages of the written down value method of depreciation:
- Under this method the book value of an asset cannot be reduced to zero.
- The rate of depreciation has to be very high if the written down value is to be brought down to its estimated scrap value.
- This method is not suitable for an asset having a very short life. The calculation of the rate of the depreciation becomes very difficult and creates problems in this case.
The written down value or the reducing balance method of depreciation is suitable for costly and wearing assets such as plant, machinery and heavy motor vehicles like lorry etc. where the question of repairs is very important and which have a residual value.
So that was all about the written down value or the reducing balance method of depreciation. I hope that you found this article helpful. Thank you and keep learning!