What is Diminishing Balance Method? Its Meaning and Formula

The Diminishing Balance Method is a widely used depreciation technique in accounting that applies higher depreciation costs in the initial years of an asset’s life, gradually reducing the amount over time. This method reflects the declining efficiency of an asset, aligning depreciation expenses with its actual usage.

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Diminishing Balance Method Meaning

The Diminishing Balance Method, also known as the Reducing Balance Method, calculates depreciation as a fixed percentage of the asset’s book value. Since the book value decreases each year due to annual depreciation, the depreciation expense also declines progressively. This method ensures that a significant portion of the asset’s cost is accounted for in the early years, aligning with the decreasing productivity and increasing maintenance costs over time.

Diminishing Balance Method Formula

Where:

• Original Cost refers to the initial purchase price of the asset.
• Estimated Scrap Value is the expected residual value at the end of the asset’s useful life.
• Depreciation Rate is the percentage applied to calculate the depreciation amount.

Uses of Diminishing Balance Method

• It is often used for rapidly depreciating assets or sensitive to technical changes.
• It is especially well-suited for assets where the early years of fall in value are more marked, such as computers, software, and equipment.
• Considering elements that affect an asset's usability and worth over time, the diminishing balance technique provides a more accurate representation of an asset's true value.

Steps to Determine Depreciation Using Diminishing Balance Method

• Determine the rate of depreciation.
• Subtract the asset cost from the scrap value.
• Add the book value to the depreciation rate.

Advantages of the Diminishing Balance Method

Below we've mentioned the advantages of the diminishing balance method:

Reflects Realistic Asset Usage: The method recognizes that asset efficiency decreases over time.

Balanced Cost Allocation: Allocates higher depreciation in the early years, reducing the tax burden and aligning with maintenance costs.

Tax Benefits: Accepted under the Income Tax Act, making it a preferred method for businesses.

Mitigates Obsolescence Risks: By writing off a larger portion early, it minimizes losses due to outdated assets.

Ideal for Long-Lasting Assets: Particularly useful for fixed assets with rising repair and maintenance costs.

Limitations of the Diminishing Balance Method

Below we've mentioned some limitations of this method:

Incomplete Depreciation: The asset's value never reaches zero, as depreciation is always calculated on a written-down value.

Complex Rate Determination: Deciding an appropriate depreciation rate can be challenging.

Example of the Diminishing Balance Method

Consider a company purchasing a car for INR 5,00,000, with an expected lifespan of 10 years and a residual value of INR 24,000. Using a 60% depreciation rate, the first-year depreciation is calculated as:

Depreciation Expense = (500,000 – 24,000) × 60%

= INR 2,85,600

This means the book value of the asset for the next year will be INR 2,14,400, and the depreciation will be recalculated accordingly.

The Diminishing Balance Method is an effective depreciation technique for assets with high initial wear and tear. It provides businesses with a more practical approach to asset valuation while ensuring tax benefits and realistic cost distribution. By applying this method, companies can make informed financial decisions, optimizing their asset management strategies.

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