What it means
When you buy equipment, vehicles, or technology for your business, you do not expense the full cost immediately. Instead, you spread the cost over its useful life using depreciation.
The reducing balance method accelerates this process, recognising higher costs upfront when the asset is newest and most productive. This approach mirrors real-world usage.
Many assets, particularly technology and vehicles, lose value much faster in their first few years than they do later on. By matching higher depreciation charges to earlier periods, your profit and loss statements reflect a realistic picture of asset efficiency and maintenance costs over time.
For non-finance managers, understanding this method helps explain why book values shrink quickly at first. It impacts your net profit figures, tax calculations, and balance sheet totals.
While it lowers early profits compared to the straight-line method, it reduces tax liabilities sooner, freeing up cash flow for reinvestment. In practice, you apply a constant percentage to the remaining net book value, rather than the original purchase price.
As the book value drops year on year, the depreciation charge naturally reduces alongside it, creating a declining curve of expense recognition. Imagine a brand new car driven off the forecourt.
It loses a huge chunk of its market value immediately, and smaller amounts of value in subsequent years as it ages and accumulates mileage.
In practice
Real-world examples
Example 1
A graphic design studio buys a high-end computer for $2,000. Using a 30% reducing balance rate, the first year depreciation is 2,000 x 30% = $600, leaving a book value of $1,400 for the next year. In year two the charge falls to 1,400 x 30% = $420.
Example 2
A regional delivery firm purchases a delivery van for $15,000. Applying a 25% reducing balance depreciation rate, the business records a $3,750 expense in year one and $2,813 in year two (11,250 x 25%, rounded). The charge falls each year because the rate is applied to a shrinking book value.
Example 3
A boutique hotel invests $10,000 in commercial kitchen ovens. With a 20% reducing balance rate, the depreciation charge starts at $2,000 in year one, dropping to $1,600 in year two. The hotel's accountant notes that the ovens will never reach a book value of exactly zero, so a residual value or write-off rule is needed at the end of their life.
Think of it
Imagine a brand new car driven off the forecourt. It loses a huge chunk of its market value immediately, and smaller amounts of value in subsequent years as it ages and accumulates mileage.
Formula
Calculation
Depreciation Charge = Opening Net Book Value x Fixed Depreciation Percentage. Closing Net Book Value = Opening Net Book Value - Depreciation Charge.
Worked example: an asset costs $10,000 and the rate is 20%. Year 1 = 10,000 x 20% = $2,000 depreciation, and the net book value becomes $8,000. Year 2 = 8,000 x 20% = $1,600 depreciation, and the net book value becomes $6,400. This process repeats annually.
Compare it with straight-line depreciation. Take a $10,000 asset depreciated at 30% on a reducing balance: year 1 is $3,000 (book value $7,000), year 2 is 7,000 x 30% = $2,100 (book value $4,900), and year 3 is 4,900 x 30% = $1,470 (book value $3,430). Straight-line over five years would charge 10,000 / 5 = $2,000 every year, so the reducing balance charge is higher in years 1 and 2 and lower from year 3 onward.Case study
Seen in the real world
This is a fictional, illustrative scenario. BrightSpark Logistics purchased sorting machinery for $50,000 to handle rising customer orders. The finance team chose the reducing balance depreciation method at a rate of 25% per year, reflecting the heavy initial wear and tear the machines would face. In the first year, BrightSpark recorded a depreciation expense of $12,500, leaving a net book value of $37,500 on the balance sheet. This higher expense reduced taxable income significantly during a year of heavy capital outlay, preserving cash.
In the second year, the depreciation charge was 25% of the remaining $37,500, equalling $9,375. By year three, the expense decreased further to $7,031. This declining expense profile helped offset rising maintenance costs as the machinery aged, balancing out overall operational expenses on the profit and loss statement. After three years, total depreciation was 12,500 + 9,375 + 7,031 = $28,906, leaving a net book value of about $21,094. The finance team compared this with straight-line over eight years, which would charge 50,000 / 8 = $6,250 a year and total $18,750 over the same period, so reducing balance had moved more cost into the early years.
Watch out
Common mistakes
- Applying the depreciation percentage to the original purchase price every year instead of the diminishing net book value.
- Continuing to depreciate an asset below its estimated residual scrap value.
- Switching depreciation methods frequently without a valid accounting reason or proper disclosure.
Questions
People also ask
Why use reducing balance instead of straight-line depreciation?
It matches higher asset productivity and maintenance costs in the early years with higher depreciation charges, and often provides tax advantages sooner.
Does reducing balance depreciation affect company cash flow?
Depreciation is a non-cash expense, so it does not directly affect cash, but higher early depreciation can reduce tax payments, which improves cash flow.
Can I change my depreciation rate later?
Rates should remain consistent, but if the estimated useful life of the asset changes significantly, you may adjust the rate prospectively.