The topic in this post is related to ACCA F7 Financial Reporting subject. I will try to highlight a concept which is sometimes overlooked by students with respects to a depreciation method called reducing balance method.
What is Reducing Balance Method?
We all know that the reducing balance is a depreciation method which is used as an alternative to the commonly used straight line method. This method assumes that an asset loses more value during the earlier years of its life. Consequently, a depreciation rate (%) for reducing value is used, resulting in less value being lost each year. It is often used for tax purposes, but less often in published accounts.
What is often overlooked?
Although students have the understanding of the method and know how to use this method to depreciate a certain fixed asset, what is often overlooked is whether this method takes into account of the scrap value of the asset. For example, if a reducing balance of 25% is used to depreciate an asset, some students are often unsure if this 25% considers the scrap value(the residual value) of the asset at the end of its life.
The Fact
The fact is that this 25% is derived after taking into consideration of the scrap value. Let's take an example. The cost of the asset is $20,000. The scrap value is 2,000. Life is 8 years. If we input the given information in the following formula, we will get to the answer of 25% reducing balance.
1 - n √(s/c) ,
where
n is life,
s is scrap value,
c is cost.
25% is derived after taking account of the scrap value $2,000. If the scrap value is zero, the depreciation will be 100% which will never reduce the cost of the asset. Thus what is clear is that scrap value is critical in deriving the reducing balance percentage and that without the scrap value, the method will be very unlikely to be used.
Conclusion
The reducing balance method always uses the scrap value.
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