Under this method, as the value of asset goes on diminishing year after year, the amount of depreciation charged every year goes on declining. The amount of depreciation is calculated as a fixed percentage of the diminishing value of the asset shown in the books at the beginning of each year. Under this method the value of an asset never comes to zero.
For example, the cost of the asset is INR 40,000 and the percentage to be written off each year is 10%. In the first year, the amount of the depreciation will be INR 4,000 (10% of INR 40,000). This will reduce the book value to INR 36,000 (INR 40,000 – INR 4,000). Now, at the beginning of the next year the book value is INR 36,000. The amount of the depreciation for the next year will be INR 3,600 (10% of INR 36,000). Thus, every year the amount of the depreciation will go on reducing. This method of charging depreciation is also known as Reducing Balance Method or Written Down Value method.
Merits of Diminishing Balance Method
1. Equal Burden on Profit & Loss Account
The productivity of the asset is more, hence its contribution to profit is also relatively greater. Therefore the cost charged in terms of depreciation should also be greater.
In the initial year, the depreciation charges are more and repair expenses are less. In later years, depreciation charges are less and repair expenses are more. Hence, the total burden, depreciation plus repair expenses, is some what equal on Profit & Loss Account for each year.
Limitations of Diminishing Balance Method
1. Asset cannot be completely written off
Under this method, the value of an asset is not reduced to zero even when there is no scrap value.
Under this method, the rate of depreciation cannot be determined easily.