Under reducing installment method, the amount of depreciation is calculated by applying a fixed percentage on the book value of the asset each year. In this way, the amount of depreciation each year is less than the amount provided for in the previous year. This is because the book value on the basis of which computation of depreciation expense is based keeps getting reduced from year to year.
XYZ company purchased a truck for $75,000 on January 1, 2016. It estimates depreciation at 20% per year on book value. Calculate the truck’s depreciation for 20016, 2017, and 2018.
Book value (original cost for the first year) at the beginning of the year 2016: $75,000
Depreciation for the year 2016: $75,000 × 0.2 = $15,000
Book value at the beginning of the year 2017: $75,000 – $15,000 = $50,000
Depreciation for the year 2017: $50,000 × 0.2 = $10,000
Book value at the beginning of the year 2018: $50,000 – $10,000 = $40,000
Depreciation for the year 2018: $40,000 × 0.2 = $8,000
Notice that the depreciation provided in the year 2018 ($8,000) is less than the amount of depreciation provided for in the year 2017 ($10,000), which in turn is less than the amount provided for in the year 2016 ($15,000). The reason is that the rate of depreciation (20% in this case) is being applied to book value, which keeps on reducing each year. In 2016, the book value was $75,000 while in 2017 it came down to $50,000 and a year later to $40,000. Remember that the rate of depreciation remains the same from year to year but it is applied to a lesser amount (i.e., book value) each year, hence a lower amount of depreciation each year.
Reducing installment method is also known as reducing balance method. It is particularly useful for fixed assets whose value deteriorates faster in their earlier years of usage. Examples of such assets are motors vehicles, smaller machinery, office equipment, etc.