When calculating the amount of depreciation, companies can apply various existing methods that are the most optimal for the features of their functioning. One such option is the reducing balance method. This method must be specified in the accounting policy of the company.
Different depreciation methods are based on a formula. This formula is obtained on the basis of a study of the behavior of assets over a specified period of time.
In straight-line depreciation (linear depreciation), an entity includes an equal amount of depreciation expense for each year of the asset's life. The residual method, also known as the diminishing asset method or the accelerated method, carries forward a large amount of depreciation in the early years of an asset's life. This concept works well if a business wants to receive a substantial tax deduction, but at the same time reduces the tax credit for depreciation in subsequent years. Let's learn more about this method in this article.
Concept
Under the residual method, depreciation is charged at a fixed percentage of the asset's carrying amount. Insofar asthe book value decreases every year, therefore, the amount of depreciation also decreases every year. With this method, the value of an asset never drops to zero.
When the amount of depreciation calculated by this method and the corresponding period are plotted on the chart, a downward trending line is formed.
This method is based on the assumption that in earlier years the cost of repairing and rebuilding assets was low, and therefore a large amount of depreciation should be charged. In addition, in subsequent years, the cost of repairs increases and, consequently, the amount of depreciation will be reduced. So this method results in the same burden on profit every year.
However, under this method, if the applicable depreciation rate is not appropriate, it may happen that full depreciation is not achieved at the end of the life of the asset. Also, when applying this method, the period of use of the asset should be taken into account. If an asset is only used for 2 months of the year, depreciation will only accrue over 2 months.
Scope of the method
The residual method is used as a variant that allows measuring the value of property in a situation where objects are characterized by uneven returns during the period of application. At the same time, the potential of the object is used precisely in the first years of its use. An example of such objects is digital technology, which is characterized by very rapid obsolescence.
Application possibilitiesof this methodology are stipulated in PBU 6/01 “Accounting for fixed assets”. This depreciation option differs significantly in its concept from the linear method.
Thus, the situations for applying this method are as follows:
- unique equipment;
- cars;
- office furniture;
- equipment up to three years.
What is asset depreciation reduction?
Asset depreciation reduction is a method of calculating depreciation in which an asset is spent at a fixed percentage.
Declining balance depreciation helps reduce the amount of depreciation as an expense each year. In other words, more depreciation is charged at the beginning of an asset's life, and less is charged towards the end.
This can be useful when an asset has a higher utility or productivity at the start of its useful life. For example, many types of machines have higher functionality when they are new, and therefore generate more revenue compared to the last years of their life. Reducing asset depreciation ensures that depreciation costs reflect the performance, functionality, and ability of assets to generate income.
Formula for calculating the depreciation rate
Calculating the correct depreciation rate is very important with this method. The following Remainder method formula:
r=1 - (S / C) 1 / n, where:
- r - depreciation rate;
- n -expiration date of the object;
- S - the value of the object in terms of the balance after the expiration date;
- C - initial cost of the object.
Calculation example:
If n=3 years, S=64,000 and C=1,000,000, then calculate the depreciation rate.
r=1 - (64,000/1,000,000) 1/3
=1 - 40/100=60/100=60%
What do you need to know for calculations?
To calculate the reduction in depreciation of an asset, you need to know:
- Asset value: The initial cost of the item plus any additional costs necessary to prepare the asset for its intended use.
- Residual value: also known as salvage value. This is the value of the asset after the expiration date.
- Depreciation rate: This corresponds to the percentage at which the asset will be depreciated each year. For example, 2 is 200%, 0, 5 is 50%.
Calculation steps
Using the available information, the residual method allows you to calculate depreciation in two steps:
Step 1. Calculate depreciation using the following formula:
Depreciation expense per year=(net book value - residual value)depreciation indicator
Step 2. Calculate the depreciation expense from the current book value to calculate the remaining book value.
These steps must be repeated each time as the object is applied. In the last year, deduct the residual value from the current book value andrecord the amount as an expense.
Keep in mind that this is only one way to calculate residual value.
Why are there different depreciation methods?
In straight line depreciation, an entity recognizes an equal amount of depreciation expense for each year of the asset's life. Declining balance depreciation carries over more depreciation in the early years of the asset's life. This works well if a business wants a larger immediate tax credit but reduces the depreciation tax credit in later years.
Calculation of amounts
When using the declining balance method, the asset's accruals are amortized at a higher interest rate than straight line depreciation. To calculate declining balance depreciation, do the following:
- Calculate the straight line depreciation percentage based on the term of use and multiply it by two. For example, if the term is 10 years, it will be depreciated at 10 percent per annum on a straight line and 20 percent per annum on a declining balance.
- Multiply the asset's book value by double the declining percentage to find the depreciation expense. For example, if an asset is worth 5,000,000 rubles, then under the declining balance method, depreciation will be 20 percent of 5,000,000 rubles, or 1,000,000 rubles.
- Deduct the accumulated depreciation from the asset's original cost to find the current book value. In this example, the newthe current book value is RUB 5,000,000 minus RUB 1,000,000 or RUB 4,000,000.
- Next year, multiply the new book value by twice the asset's declining rate to find that year's depreciation. In our example, this will be 20 percent of 4,000,000 rubles or 800,000 rubles.
- Repeat the operation until the asset is fully depreciated.
Example of residual method 1
The company buys a van for 5,000,000 rubles. The company estimates that the van will lose 40% of its value every year, with a depreciation cost of 1,000,000 rubles. Following the decreasing balance method, the first five years of depreciation would look like this:
| Years | Calculation 1 | Depreciation allowance | Calculation 2 | Balance value |
| Initial cost | 5,000,000 | |||
| 1 | (5,000,000 - 1,000,000)0, 4= | 1,600,000 | 5,000,000-1,600,000 | 3,400,000 |
| 2 | (3,400,000 - 1,000,000)0, 4= | 960 000 | 3,400,000- 960,000 | 2,440,000 |
| 3 | (2,440,000 -1,000,000) 0, 4= | 576 000 | 2,440,000 -576,000 | 1 864 000 |
| 4 | (1 864 000 -1 000 000) 0, 4= | 346 000 | 1,864,000- 346,000 | 1,518,000 |
| 5 | (1,518,000 -1,000,000) 0, 4= | 207 000 | 1,518,000 - 207,000 | 1 311 000 |
Second example
Assume that the value of the asset is 1,000,000 rubles, and the depreciation rate is 10% per annum.
| Asset value | 1,000,000 rubles |
| Depreciation | |
| 1 year: 10% of 1,000,000 | 100,000 rubles |
| Residual value | 900,000 rubles |
| 2nd year: 10% of 900,000 rubles | 90,000 rubles |
| Residual value | 810,000 rubles |
| Year 3: 10% off RUB 810,000 | 81,000 rubles |
| Residual value | 729,000 rubles |
In the fixed method, the amount of depreciation remains constant, but in the reducing balance method, the amount of annual depreciation is gradually reduced. It's a fact!
When analyzing residuals, the reduction method is suitable for assets withlong service life, such as machinery and equipment, furniture, cars, etc.
According to this method, the real value in use of an asset is the cost of depreciation and repairs. It gives better results because in the early years, when repair costs are lower, depreciation is higher. As an asset ages, the cost of repairs increases and the amount of depreciation decreases. Thus, the cumulative impact of the two types of costs remains almost constant value in the amount of profit each year.
The disadvantage of this method is that it takes a long time for the asset to be written down to zero, unless a very high rate is used, in which case the burden on earlier years would be excessive.
Comparison with linear depreciation
An alternative method is straight line depreciation. Whereas the declining balance method option charges depreciation as a percentage of the asset's carrying amount, the straight-line method uses the same amount each year.
Linear wear cannot account for higher levels of performance and functionality early in an object's life. However, for most small businesses, it is enough. They are much more comfortable using the linear method.
Difference between techniques
The following are the main differences between the direct method and the residual depreciation method.
| n/n | The straight-line method | n/n | Method of leastbalance |
| 1. | The level and amount of depreciation remain the same every year. | 1. | The rate remains the same, but the amount of depreciation is gradually reduced. |
| 2. | Depreciation percentage is calculated from the value of assets every year | 2. | Depreciation percentage is calculated from the book value of the asset. |
| 3. | At the end of the asset's life, the value of the asset is reduced to zero or the value of the remainder. | 3. | The value of an asset never decreases to zero at the end of its life. |
| 4. | The older the asset, the greater the cost of repairing it. But the amount of depreciation remains the same every year. Consequently, the amount of wear and tear increases every year. This reduces the annual profit gradually. | 4. | The amount of depreciation is gradually decreasing, and the cost of repairs is increasing. Thus, the total amount of wear and tear remains more or less the same every year. Therefore, this results in little or no change in annual profit/loss. |
| 5. | Calculating straight-line depreciation is relatively simple. | 5. | Depreciation can be calculated without any difficulty, but with some difficulty. |
We compare the two methods on specific calculation examples.
Linear method example:
Equipment in the form of a machine has a cost of 423,000 rubles. Application period - 8 years.
Depreciation amount per year: 423,000: 8=52,8775 rubles
Another option: calculate the annual percentage of depreciation: 100/8=12.5%
Depreciation amount: 423,00012.5% =RUB 52,875
Decreasing balance method example:
Initial data: annual depreciation rate 12.5%.
The amount of depreciation in 1 year is the same: 52,875 rubles
This amount is subtracted from the cost of the machine in year 2: 423,000- 52,875=370,125 rubles
Depreciation in the second year: 370,125 12.5% =RUB 46,266
Monthly depreciation amount: 46266 /12=3855 RUB
Second year residual value:
370 125 – 46 266=RUB 323 859
Further, the calculations follow the same pattern for 8 years.
Acceleration factor
However, the above examples do not take into account the fact that the fixed asset can be used very intensively, that is, wear out much faster. In such a situation, we add one more variable value to the calculation formula - the depreciation acceleration factor. It can be no higher than 3 (clause 19 PB 6/01). It can only be used in the case of the decreasing balance method. In other depreciation options, it is considered unjustified.
In general, the value of this indicator is set by the companyindependently and stipulated in its accounting policies. But its value must have a convincing justification. As such, the technical documentation of the facility, permits from authorities, work schedules, time sheets, acceptance certificates, etc. can be used.
The formula of the residual method using this indicator looks like this:
GN=1100 Ku/SPI, Annual depreciation=OSGN, Depreciation every month=Annual depreciation /12, OS=P - ON, where:
- Ku is an accelerating factor that the company sets for itself. Value between 1 and 3;
- SPI - useful life of the OS object;
- PS - initial cost - this is the value by which the object is accepted for accounting in the company;
- NA - accumulated depreciation, this is the amount of deductions for the object for the entire service life;
- OS - residual value, this is the difference between the initial cost and the amount of depreciation;
- GN - annual depreciation rate - a value in%, reflecting the share of the cost of the object, which is charged to expenses every year.
Dry balance method in depreciation
This concept is used in case of early retirement of funds, that is, in a situation where a company has to "part" with fixed assets before their useful life expires. At the same time, during liquidation, the amount of undercharged depreciation remains.
Applying the Property Methodology
Remainder method inproperty valuation can be used in relation to land. It is carried out taking into account the factors of profit formation. Initially, this method was developed in relation to agricultural land. In this situation, income is considered as residual. The methodology evaluates a piece of land with improvements in relation to its commercial use. Conduct an analysis of the most effective variant of its application with a focus on generating income.
Benefits of a diminishing balance
The main advantage of the method is the tax benefit. According to the declining balance, the entity can apply higher depreciation tax deductions at an earlier date. Most businesses are likely to receive tax breaks sooner rather than later. From a financial accounting perspective, the reducing balance method makes sense for assets that lose value quickly, such as new cars and other vehicles. For these assets, a decrease in balance sheet depreciation better balances the depreciation expense against the actual decline in fair market value.
The use of the method is justified when the OS object needs to be decommissioned quickly. For example, a computer. Since more progressive models appear every year, even when the deadline for this object has not come to an end, the computer may no longer be able to cope with the tasks.
Disadvantages of the methodology
There are some tax scenarios in which a company may not want to apply larger tax credits earlystage. For example, if a company already has a tax loss for the year, it will not receive an additional tax deduction. Spreading the deductions evenly can help businesses avoid higher tax payments in subsequent years. For assets that do not lose value quickly, such as equipment and machinery, the accelerated depreciation method does not make logical sense. You can more accurately depreciate these assets based on how much they are used.
Conclusion
The diminishing balance method is especially relevant for OS objects that wear out very quickly (including morally). The cost of such an object is written off by means of monthly depreciation, starting from the month following the time of acquisition of this object. Residual method - a type of valuation of fixed assets. This is understandable.
When determining by the residual method, based on the use of the residual value and the accelerating factor.
The calculation in this way is based on the value of the residual value, which allows you to have maximum deductions in the first months and years of the object's use. And then over time, these amounts decrease. With the introduction of an additional accelerating factor by the company, the write-off process becomes even faster. But the use of such an indicator must be justified.
