Reducing Balance Method

1. Reducing Balance Method • This method assumes that more value is lost at the start of the life of an asset, than at the end • We use a fixed percentage – e.g. 20% • We assume that the asset loses this percentage of its start of year value in depreciation

2. Reducing Balance Method – An Example • An asset was bought for £10,000. We will use it for 3 years. We will depreciate it 20% each year using the reducing balance method. Year 1 – Start value = £10,000 It depreciates by 20% = 20% of £10,000 = £2,000 It is now worth £8,000 Year 2 – Start Value = £8,000 It depreciates by 20% = 20% of £8,000 = £1,600 It is now worth £6,400 Year 3 - Start Value = £6,400 It depreciates by 20% = 20% of £6,400 = £1,280 It is now worth £5,120

3. Depreciation and Profit • Because depreciation is looking at the loss of the value of an asset, it reduces profit • We treat depreciation as an expense when calculating profit • So if an asset depreciates by £1,000 – we have an extra £1000 costs that year…. • ….and profit will be reduced by £1,000

4. Differences in Methods • Depending on which method you use, you could end up with very different figures for depreciation • If depreciation is high, expenses will be high, and therefore profits will be low • If depreciation is low, expenses will be lower, hence profits will appear high • That’s why the accountant in a business must choose an appropriate method of deprecation depending on the type of asset, how its used, what its used for, etc, etc • As you could imagine, depreciation is very much guess work, and some businesses have been found out trying to mislead people by recording very high or low depreciation figures