When using a diminishing (or declining) balance method for calculating depreciation, we use the carrying value (also known as book value) because this approach focuses on the idea that the asset’s value declines at a certain percentage of its remaining value each period.
Here’s a breakdown of why carrying value is used in this method:
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Reflects Actual Use: The diminishing balance method assumes that the asset loses more value in the earlier years of its life when it is typically more productive and valuable. By applying the depreciation rate to the carrying value, this method captures the actual reduction in the asset's utility and market value over time.
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Remaining Value Consideration: As the asset depreciates, its carrying value decreases. By using the carrying value as the basis for depreciation, the method ensures that the amount of depreciation reflects the asset's current financial state, not just its original cost. This method adjusts for the fact that an asset's ability to generate revenue may decrease over time, thus producing a more accurate representation of economic reality.
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Financial Reporting: In financial statements, the carrying value provides a more realistic view of an asset’s worth, allowing stakeholders to see how much of the asset's value has been consumed or lost over time. This is important for investors, creditors, and management when assessing the financial health and performance of the company.
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Simplified Calculations: Using a fixed percentage on the carrying value simplifies the calculations over the asset's life. This approach results in a decreasing depreciation expense over time, which aligns with the diminishing utility and revenue-generating potential of the asset.
In summary, using carrying value in the diminishing method for depreciation helps to track the actual reduction in value of an asset over its useful life, leading to more accurate financial reporting and analysis.