What is under reducing balance method depreciation?

Depreciation in accounting is a way of allocating the cost of an asset over its useful life. In the United Kingdom, there are two methods to calculate depreciation: the straight-line method and the Reducing Balance Method.  It is reducing balance depreciation where depreciation reduces gradually over the years. This method offers a systematic way to allocate the cost of an asset while considering its diminishing value over time.

The Basics of the Reducing Balance Method

The Reducing Balance Method, also known as the declining balance method or diminishing balance method, is a form of accelerated depreciation. Unlike the straight-line method, where the same amount of depreciation is charged each year, the  reducing balance depreciation charges is higher in the earlier years of an asset’s life and gradually decreases as the asset becomes older.

How Does It Work?

In the reducing balance method, the depreciation expense is calculated based on a fixed percentage of the asset’s carrying amount, i.e., the initial cost minus the accumulated depreciation. This fixed percentage, often referred to as the “depreciation rate,” is usually higher than depreciation charge under the straight-line method.

• Here’s an example to illustrate the process

Suppose ABC Ltd. purchases machinery for £50,000 with a useful life of five years and a depreciation rate of 25%. In the first year, the depreciation expense would be £50,000 * 25% = £12,500. The carrying amount of the asset is £37,500 (£50,000–£12,500). In the second year, the depreciation expense would be calculated as 25% of £37,500, resulting in £9,375. The process continues until the asset carrying amount reaches a predetermined residual value or becomes negligible.

Advantages and Considerations:

The reducing balance method offers several advantages to businesses in the UK:

• Reflection of Asset Value:

This method better reflects the economic reality of many assets, which tend to lose value more quickly in their earlier years and at a slower pace later on.

• Matching Expenses with Revenues:

By charging higher depreciation in the earlier years, businesses can align their expenses with the higher revenues often generated when assets are new and productive.

• Tax Benefits:

The accelerated depreciation in the initial years leads to higher expenses, which can result in lower taxable income and, consequently, reduced tax liabilities.

However, there are certain considerations that we need to keep in mind:

• Complexity:

The reducing balance method can be more complex to calculate and manage compared to the straightforward nature of the straight-line method.

• Asset Valuation:

Determining an appropriate residual value and depreciation rate requires careful consideration to ensure they accurately reflect the asset’s characteristics and market trends.

• Financial Reporting:

While the reducing balance method is acceptable under UK Generally Accepted Accounting Principles (GAAP), it’s important to be transparent about the method chosen in financial statements.

Depreciation for tax compliance

As per HMRC rules, depreciation is not tax deductible. It comes under a special set of rules – Capital allowances. Although you still have to follow accounting rules for depreciation, HMRC replaces depreciation with capital allowances for tax purposes. It works differently from allowing 100% to 6% of the cost every year.

How can Meru Accounting help?

Meru Accounting is one of the leading outsourced bookkeeping and accounting service providers for clients across the globe. Our team of experienced and qualified CPAs, CAs, and accountants is well-versed in UK accounting and tax laws. We have years of experience in serving UK clients and ensuring HMRC compliance with accounting and taxes.

FAQs

1. What does the reducing balance method mean in simple terms?
   The reducing balance method is a way to spread the cost of an asset over its life. You charge more in the first years and less as the asset gets older.
2. Why do firms in the UK use this method?
   Firms use it since it shows real asset use. New assets lose more value fast, so this method gives a fair view of their drop in worth.
3. How is this method not the same as the straight-line method?
   The straight-line method charges the same cost each year. The reducing balance method starts high and then gets lower with time.
4. What is a good case for using this method?
   This method is best for tools, gear, or tech that lose value quickly. It helps match costs with the high gains made in early years.
5. Does the reducing balance method help with tax in the UK?
   In UK tax law, you do not claim tax relief on book depreciation. HMRC uses capital allowance rules. Yet, this method helps in clear books.
6. How do you work out the charge each year?
   You set a rate, like 25%, and apply it to the net book value each year. As the value drops, the charge gets less.