When you buy an asset for your business, you can deduct the expense on your business tax return. Anything you use or dispose of within one year, like stationery supplies, are deducted in the year you make the purchase. Other assets have a long-term life. These assets are deducted over the years you use them until their recorded value becomes zero. One way to depreciate assets is via the diminishing value method. This method is appropriate when an asset loses value quickly in the early years of its life but then loses less value over time.
How the Depreciation Process Works
Where an asset has a useful life of two, five or even 20 years, the Internal Revenue Service will not allow you to deduct the entire cost in the year of purchase. Instead, you have to reduce the cost of the asset systematically, year-after-year, until the recorded value of the asset becomes zero. The default method of doing this is via the straight-line method. Here, you allocate a fixed dollar amount of depreciation every year over the useful life of the asset. So, if you bought a machine for $50,000 and placed it in service for 10 years, the annual depreciation expense would be $50,000 divided by 10 or $5,000 per year.
Diminishing Value Depreciation Definition
While beautiful in its simplicity, the straight-line method is often out of step with what's happening on the ground. Many assets such as computer equipment quickly become obsolete and lose most of their value in the earlier years of their life compared to their later years. A delivery truck, for example, might lose 20 percent of its value every year for 10 years. If you bought the truck for $50,000, it would be worth $40,000 after the first year, $32,000 after the second year and so on. Where the early years need to be weighted more heavily, it's better to use the "diminishing value" or "reducing balance" method of depreciation as this gives a more accurate result.
How Do You Calculate the Diminishing Method of Depreciation?
The calculation looks like this:
Annual depreciation = (Net Book Value - Salvage Value) x percentage rate
- Net Book Value is the asset's value at the start of each year. You calculate it by deducting the total depreciation from the purchase cost of the asset.
- Salvage Value is how much you can sell the asset for at the end of its useful life. So if you think you could sell your delivery truck for $5,000 after 10 years, then the salvage value would be $5,000.
- Rate of depreciation is the percentage of its value the asset will lose for each year of its useful life.
While it's simple enough to run this calculation manually, you can also use an online diminishing value depreciation calculator to calculate the values you need for your financial statements.
Example of a Diminishing Value Calculation
Suppose a photocopier has a useful life of three years. The asset cost $2,000, and you'll be able to sell it for $500 when you're through with using it. The rate of depreciation is 30 percent. Plugging these figures into the diminishing value depreciation rate formula gives the following depreciation expense:
Year 1: (2,000 - 500) x 30 percent = $450
Year 2: (1,550 - 500) x 30 percent = $315
Year 3: (1,235 - 500) x 30 percent = $220
When using the diminishing value method, you would record the final year's depreciation as the difference between the Net Book Value at the start of the final period (here $1,235) and the Salvage Value ($500). This ensures that depreciation is charged in full. So, in this example, you would record year three's depreciation as $735. Nonetheless, you can see how the depreciation expense progressively declines over the asset's useful life rather than being a fixed amount for each period.