Diminishing value depreciation is one of the main methods used to write off an asset's value over time. Because it accounts for declining value, it's often used to write off assets that deliver less value as they age.
In this guide, we'll go over the meaning, use and formula for diminishing value depreciation, and look at other depreciation methods.
What is depreciation?
Depreciation, in accounting, is a way of deducting the cost of a large or expensive asset purchased for your business.
While smaller purchases can often be claimed as deductible business expenses on your tax return and balance sheet, assets with a significant purchase price may need to be deducted over multiple years - usually calculated as the expected life of the asset.
This can help you avoid going over the write-off threshold for the current year and ensure you get the full benefit of writing off a major expense.
What is diminishing value depreciation?
Diminishing value depreciation (sometimes called declining balance or diminishing value depreciation) is a way of calculating the changing value of an asset over time, so it can be written off or deducted in line with its value to your business.
In essence, you split the cost of the asset over its useful life, charging a higher proportion of the value at the beginning, and a smaller proportion as the asset ages.
When should you use the diminishing value depreciation method?
The diminishing value depreciation method is most useful for assets that deliver higher value to your business at the beginning of their lives, then decline over time. For example, a laptop or piece of machinery will be most functional when brand new, which translates to higher productivity and revenue for your business. As these assets age, their functionality decreases and the value they deliver declines.
With the diminishing value depreciation method, your expenses reflect an asset's declining value to your business over time rather than simply dividing the cost evenly over your asset's lifespan.
Diminishing value depreciation method
The diminishing value formula involves the original cost of the asset, its residual or end-of-life value and the depreciation rate.
You’ll need these numbers to get started:
Asset value
The original price of the asset, along with any costs required to install or ready the asset for use.
Residual value
This is the estimated value of the asset at the end of its useful life, also called scrap or salvage value.
Asset lifespan
The expected useful life of the asset - for example, your work laptops might have an average lifespan of five years.
Now you can calculate the annual depreciation expense and then the depreciation rate.
The annual depreciation expense is the amount of your asset's cost that's deducted each year for depreciation.
Annual depreciation expense = (Cost of asset - residual value) ÷ (asset lifespan)
The depreciation rate is a percentage by which your asset's value declines over time. The higher the rate, the faster your asset is diminishing in value - depreciating.
Depreciation Rate = (annual depreciation expense ÷ cost of asset) × 100%
Once you've found your depreciation rate, you can calculate depreciation for the asset.
STEP ONE: Calculate the depreciation charge.
Net book value - residual value x depreciation factor = depreciation charge
The net book value (NBV) is essentially the value of your asset at any given point in time, rather than its original cost. Only in the first year is your asset's NBV equal to the original cost.
Accumulated depreciation then lowers the NBV over time, having been deducted from the original purchase cost in the first period and then from the current NBV in each subsequent period.
STEP TWO: Subtract the depreciation charge from the current NBV to find the remaining book value.
Net book value - depreciation charge = new net book value
The depreciation charge becomes a deduction on your tax return and a deductible expense on your Profit and Loss statement, while the remaining net book value is listed as an asset. When you recalculate the following year, the depreciation charge will be based on the lower net value amount, resulting in a lower depreciation and a smaller deduction.
Diminishing value vs double declining balance depreciation
Diminishing value and double declining balance (DDB) depreciation are similar methods of calculating depreciation - with one key difference.
Double declining balance depreciation method
The double declining balance (DDB) method is used to write off the value of an asset over time, with a higher proportion of the cost being claimed at the beginning of its lifespan. Like the diminishing value method, it's a way to balance the productivity and value delivery of an asset with the depreciation amount for a given year.
Key differences of double declining balance depreciation
The key difference between the double declining balance and the diminishing value methods is the rate of depreciation. The DDB method is sometimes called accelerated depreciation because it calculates depreciation at double the normal rate. This means you'll claim a much higher percentage of the cost in the first few years of ownership.
This can be a worthwhile strategy if your business makes a large investment and needs to write off the cost as quickly as possible.
Diminishing value depreciation vs straight-line depreciation
Diminishing value and straight-line depreciation are probably the most common methods of calculating depreciation.
Straight-line depreciation method
The straight-line depreciation method is a simple way to calculate depreciation over time. Instead of working out depreciation rates and net value, you divide the cost of the asset minus its residual value — in this case, referred to as salvage value — by the number of years it's likely to be used.
(Cost of the asset - salvage value) / useful life in years = annual depreciation expense
For example, if you buy an asset for $50,000, you estimate its salvage value as $10,000, and its lifespan as five years, the calculation looks like this:
($50,000 - $10,000) ÷ 5 = $8000
This means you can write off $8000 each year for the lifespan of the asset, eventually writing off the full value (minus salvage value, which can be recouped if you sell the asset).
Key differences of straight-line depreciation
The key differences between straight line and reducing value depreciation are the calculations used and the type of assets being depreciated. Reducing value depreciation is used for assets that deliver diminishing returns over time, and straight-line depreciation is used for assets that deliver the same or similar value throughout their lifespan.
For example, office furniture does its job in essentially the same way whether it's brand new or several years old.
Diminishing value depreciation FAQs
What are the most common methods of depreciation?
The most common methods of depreciation are prime cost, straight line, reducing or diminishing balance, and double declining balance (DDB).
What is the simplest depreciation method?
The simplest depreciation method is straight-line depreciation, which involves writing off the cost of an asset in equal sums over its lifespan. Unlike diminishing value or DDB depreciation, it doesn't require complex calculations.
What is the most effective method of depreciation?
There's no one method of depreciation that's more effective than others, as the general goal is the same. The best depreciation method depends on the asset being claimed and on the strategic goals of your business.
For example, the diminishing value method may be more suitable for electronics and machinery, while prime cost or straight-line methods work well for assets that retain their value over their lifespan.
Depreciation got you down?
Depreciation is a way to manage your finances and ensure the value of your assets is reflected in your tax returns and financial statements. It's an important tool in your financial toolkit, but like many accounting concepts, it can also be complicated for non-experts to understand. Your accountant or bookkeeper will always be helpful in ensuring you are using the best methods of depreciation for your situation.
Further, MYOB can help you cut through the complexity, with a suite of simple, user-friendly tools for managing day-to-day accounting tasks, annual reporting, and tax returns. Looking for simple, intuitive accounting software? Get started with MYOB today!
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