Depreciation Methods: Straight Line vs Reducing Balance

Depreciation refers to the decline in value of a tangible asset over time due to wear and tear, obsolescence, or other factors affecting its useful life, impairing its ability to generate income. There are two main methods used to calculate depreciation—the Straight Line Method and the Reducing Balance Method. Here's how each method works:

Straight Line Method

This is one of the most commonly used ways to estimate property depreciation because it provides a uniform rate of loss per year throughout the entire period of ownership. For example, if a company purchases a machine that costs $40,000 and expects it to last five years, they would divide the total cost by the number of years ($40,000 / 5 = $8,000) to get annual depreciation expense of $8,000. In this case, the owner can deduct $8,000 from their taxable income every year for the next five years after purchasing the equipment.

The formula for calculating depreciation using the Straight Line Method is as follows: [Depreciation = (Cost - Salvage Value) \times Rate] where (Rate) is the percentage assigned to each accounting period. For instance, with a salvage value of zero dollars, the above equation becomes [Depreciation = Cost \times Rate] which means the amount you spend on buying an item minus its estimated lifespan equals your annual depreciation expense.

Reducing Balance Method

In contrast, under the Reducing Balance Method, assets lose value at a higher rate earlier during their lives and slower rates later. This approach recognizes that assets generally don't decrease in value at the same rate every single year; they tend to depreciate more quickly in early years and less rapidly towards the end of their lifetimes. To determine depreciation charges based upon the Reducing Balance Method, you multiply the book value of the fixed asset by the appropriate fraction depending on the chosen schedule.

Just like in Straight Line depreciation calculations, one starts with the initial cost of fixed asset ((A_0)) and then adds up all past adjustments made via depreciation expense((D)), so at the end of period k, the book value of the fixed asset will be equal to[B_k=A_0+D_1+\cdots + D_{k}]. Then, depreciation charge for period (k+1) will be calculated through the following formula: [D_{k+1}=\frac{B_k}{n}%] where (n%) represents the predefined fraction associated with the given depreciation schedule. By putting together these components, you arrive at the final formula for calculating Reducing Balance Method depreciation: [D_{k+1}=(A_0-\sum_{i}^{k}D_i)\cdot n%]

While both methods have been widely adopted for financial reports preparation and tax purposes, companies usually prefer the Straight Line approach as it gives them a clear picture of what their expenses might look like over several years. On the other hand, businesses often elect to employ the Reducing Balance Method when they expect rapid technology changes could cause faster declines in machinery values.

Learn about the Straight Line Method and the Reducing Balance Method for calculating depreciation of tangible assets. Understand the differences in their approaches and how each method can impact financial reports and tax obligations.