ADVANTAGES AND DISADVANTAGES OF DIMINISHING BALANCE DEPRECIATION METHOD

Advantages:

1. Higher Depreciation in Initial Years: Diminishing balance depreciation method allows for higher depreciation charges in the initial years of an asset’s life. This is particularly beneficial for assets that are expected to have higher wear and tear or technological obsolescence early on.
2. Reflects Asset’s Usage Pattern: This method reflects the realistic pattern of an asset’s usage, as many assets tend to lose their efficiency and value faster in the early years of their useful life. Therefore, it provides a more accurate representation of an asset’s actual decrease in value over time.
3. Tax Benefits: The higher depreciation charges in the earlier years result in higher tax deductions during those years, which can lead to increased tax benefits for the company. This can improve cash flow and reduce taxable income, thereby lowering the tax liability.
4. Simple Calculation: Diminishing balance depreciation method is relatively simple to calculate compared to other depreciation methods like sum-of-years-digits or annuity depreciation. It involves straightforward computations based on the asset’s initial cost and salvage value.
5. Matching Principle: By allocating higher depreciation expenses in the earlier years, this method aligns with the matching principle of accounting, which aims to match expenses with revenues generated by the asset over its useful life. This improves the accuracy of financial reporting.

Disadvantages:

1. Decreasing Depreciation Over Time: While higher depreciation charges are advantageous in the early years, they decrease over time. This can lead to lower depreciation expenses in later years, which might not accurately reflect the asset’s actual decline in value or usage pattern.
2. Potential Overstatement of Asset’s Remaining Value: The diminishing balance method tends to overstate the residual value of the asset on the balance sheet, especially in comparison to methods like straight-line depreciation. This can affect financial ratios and misrepresent the true financial position of the company.
3. Complex to Explain: While the calculation process might be simple, explaining the rationale behind diminishing balance depreciation to stakeholders, such as investors and creditors, could be challenging. This method might seem arbitrary or less intuitive compared to other depreciation methods.
4. Risk of Manipulation: Since the depreciation charges can vary significantly depending on the chosen depreciation rate and the asset’s initial cost, there’s a risk of manipulation for financial gain. Companies might be tempted to adjust these parameters to meet specific financial targets or objectives.
5. Regulatory Compliance: In some jurisdictions, regulatory bodies might have specific guidelines or restrictions regarding the use of diminishing balance depreciation. Failure to comply with these regulations could lead to legal issues or penalties for the company.

While the diminishing balance depreciation method offers advantages such as higher initial depreciation, tax benefits, and simplicity in calculation, it also comes with drawbacks like decreasing depreciation over time, potential overstatement of asset value, and challenges in explanation and compliance. Companies should carefully consider these factors when choosing their depreciation method to ensure accurate financial reporting and compliance with regulations.