Reducing balance depreciation requires three items for calculation: The asset’s book value, annual depreciation percentage, and salvage value. Most depreciation calculations concern machines or other types of equipment a business owns. The reducing balance depreciation is calculated by taking the asset’s book value less its salvage value times the annual depreciation percentage. Accountants will then divide this number by 12 months and post this figure into the company’s general ledger.
Not all machines or equipment will have a salvage value. If the company decides to retain the equipment until it runs out of useful life, the machine will most likely be scrapped when taken out of service. Scrap value is often too low to affect the reducing balance depreciation calculation.
The annual depreciation percentage is typically an accounting estimate. Accountants can determine the use percentage each year according to the company, or by an estimate provided by the equipment manufacturer. For example, a machine purchased for $125,000 US Dollars (USD) has a salvage value of $5,000 and a useful life of 10 years, per manufacturer recommendations. Accountants estimate the annual depreciation percentage as 20 percent annually, based on usage estimates from the manufacturer and the company’s production supervisor. Depreciation for the first year is $24,000 USD annually ((125,000 – 5,000 ) * .20). The second year’s annual depreciation is $19,200 USD ((120,000 – 24,000) * .20). Each year, the depreciation percentage will decrease, hence the reducing balance depreciation method.
Depreciation allows companies to avoid expensing major equipment purchases. This creates a smoother net income figure, as companies must report expenses on their income statements. General accounting standards typically allow companies to use whatever depreciation method they deem necessary for their operations. A benefit of the reducing balance method is it allows for larger depreciation amounts to be expensed earlier in the equipment’s lifetime. This will reduce the company’s tax liability sooner rather than later.
Using the reducing balance depreciation method is similar to depreciation methods used for tax purposes. Government taxing authorities often require companies to depreciate machinery and equipment faster than other methods. This depreciation method is also a reducing balance method, with government tax authorities providing useful life for different classes of assets. This creates a universal method for depreciation to ensure all companies follow basic rules when reporting tax liabilities. Companies may need to create a reconciliation method between their accounting depreciation method and the tax method to ensure no improprieties exist between the two methods.