Hi, my name is Grant Hobson. I work as a finance analyst, and today I'm going to talk you through some business maths, calculations and ratios. How to calculate depreciation using the reducing balance method.
So, depreciation is basically allocating the cost of an asset over the life of the asset and the revenue it will generate over a period of time. So, there are two methods to it. There's a straight line depreciation method which you can look into which is a simplistic method.
Other's the reducing balance method and the two methods have pros and cons. But first, I'm just going to go through the methods of calculation. Basically, we just want to work out what amount of investment will be spread on each year of the life of the asset.
We'll show that now in a calculation here. Okay, so in terms of calculating depreciation using reducing balance method, what it finds out is the depreciation rate that we're going to use over this period and there's a formula here and what I'm going to do is just use the double balance method. And for this example, you can take in all of this.
So on this example, we've got an asset which is worth 100,000 pounds and it's got a five-year life. So on the straight line depreciation, we would do 100,000 pounds divided by 5 and that would give us 25,000 pounds a year depreciation which would expense into the account. The reducing balance is a bit different.
So what we need to do is say that 1 divided by 5 equals an 0.2, so it's 20% and that for the reducing balance method because we double this up, so we're going to do 20% times 2, so the depreciation rate that we use is going to be 40%. So, whereas a straight line depreciation in our case is 20,000
pounds over age of five years.
What we're saying with reducing balance is that the asset is more productive, it having more value to it when it's brand new and it will run more efficiently, so what we're going to do is depreciate the asset a lot more at the start of its useful life and then as we progress though, it will get less and less in term of depreciation. So, we'll demonstrate this now. So, I'm going to say we got here 5 years, I've got my base of 100,000, so my depreciation calculation is going to be in year one, 100,000 times by 40%, times by 0.
4, so that is 100,000 times by 0.4, so we got here an accumulated depreciation of 40,000 pounds. So in year two, it's the same approach, we're going to have now a base of 60,000 which is your 100,000 less your depreciation, and then this calculates depreciation on that list now, so 60,000 times by 40% give you 24,000, so we have now accumulated depreciation of 64,000.
So in the accounts over these 2 years, the amount we'd see, the current value of the asset would be your original investment less the key accumulated depreciation. So year three, 100,000 less your accumulated depreciation, we times this by 0.4 again, 40%, so you'll see we have our depreciation expenses reducing and we're just going to follow this through now.
So, you'll see that there's an outstanding balance which is basically because we've used an approximation for the depreciation rate and so what we need to do is just make sure, because it's not residual value on the asset, we take all this additional depreciation expense into the final year, so we would just add 7776 which means that we've started with a base of 100,000 and over the 5 years, we've accumulated depreciation for a full 100,000.