What it means
When a business buys a long-term asset like machinery or computers, it loses value as it gets older and is used. Accountancy rules require businesses to spread this cost over the useful life of the asset.
The reducing balance method accelerates this cost into the early years. You apply a constant depreciation rate not to the original purchase price, but to the current net book value, which is the original cost minus all depreciation charged so far.
This matters for non-finance managers because it directly impacts your departmental profit and loss statement. Assets are typically most productive and need the most maintenance when they are new.
Matching higher depreciation expenses with higher initial productivity provides a realistic view of profitability. It also lowers your tax bill earlier by reducing taxable income when the asset is newer.
In practice, you choose a depreciation rate based on the expected lifespan of the asset and tax regulations. Once set, you apply that same percentage to the reduced balance every year.
The asset value will never quite reach zero on the balance sheet, which realistically reflects that older equipment usually retains some scrap or residual value. Think of driving a new car off the forecourt.
It loses a huge chunk of its value in the very first year, less in the second year, and smaller amounts still as it ages.
In practice
Real-world examples
Example 1
A delivery startup buys a van for $20,000. Using a 20% reducing balance rate, the first year depreciation is $4,000, leaving a book value of $16,000 for the second year. The owner notes that the van will still be on the books for over $10,000 after three years, which is realistic for a vehicle that is still in daily use.
Example 2
A boutique hotel purchases kitchen equipment costing $10,000. With a 25% reducing balance rate, the first year write-off is $2,500, leaving a carrying value of $7,500. In year two the write-off falls to 7,500 x 25% = $1,875, so the hotel's kitchen costs are heaviest when the equipment is newest.
Example 3
An architecture firm invests $5,000 in high-end design workstations. Applying a 30% reducing balance rate, the year one depreciation is $1,500, leaving a value of $3,500. Because computers lose their usefulness quickly, the firm is comfortable with a steep first-year charge and a smaller one in year two of 3,500 x 30% = $1,050.
Think of it
Think of driving a new car off the forecourt. It loses a huge chunk of its value in the very first year, less in the second year, and smaller amounts still as it ages.
Formula
Calculation
Depreciation Expense = Opening Net Book Value x Depreciation Rate. Closing Net Book Value = Opening Net Book Value - Depreciation Expense.
Worked example: a machine costs $10,000 and the reducing balance rate is 20%. Year 1 depreciation is 10,000 x 0.20 = $2,000, so the new book value is $8,000. In Year 2, depreciation is 8,000 x 0.20 = $1,600, leaving $6,400.
Here is a three-year view for a $20,000 van at 20%. Year 1 charge is $4,000 (book value $16,000), Year 2 is 16,000 x 0.20 = $3,200 (book value $12,800), and Year 3 is 12,800 x 0.20 = $2,560 (book value $10,240). Total depreciation after three years is 4,000 + 3,200 + 2,560 = $9,760, and the asset is still carried at 20,000 - 9,760 = $10,240.Case study
Seen in the real world
This is a fictional, illustrative scenario. BrightPrint, a medium-sized commercial printing company, recently invested $50,000 in a state-of-the-art digital printing press. The operations manager needed to decide how to spread this cost on the financial statements. They chose the reducing balance method with an annual depreciation rate of 25%.
In the first year, BrightPrint recorded a depreciation expense of $12,500, reducing the asset book value to $37,500. This higher initial expense helped shield some of the strong early printing revenues from corporation tax. In the second year, the depreciation charge was calculated on the new $37,500 balance, resulting in an expense of $9,375 and a remaining book value of $28,125. By year three, the charge dropped further to $7,031.
This declining expense profile matched the reality of the machine needing more frequent repairs and losing competitive edge over time, while smoothing out future net profit figures as maintenance costs naturally rose. The finance director compared the method with straight-line depreciation over eight years, which would have charged $6,250 each year. The extra first-year charge was 12,500 - 6,250 = $6,250, which at an assumed 20% tax rate reduced the first-year tax bill by about $1,250. She was careful to explain to the board that this was a timing benefit only, because the total depreciation over the machine's life is the same.
Watch out
Common mistakes
- Applying the fixed percentage to the original cost every year instead of the diminishing net book value.
- Changing the depreciation rate randomly year on year without a valid accounting reason.
- Failing to account for the residual value when the asset is eventually sold or scrapped.
Questions
People also ask
How does this differ from the straight-line method?
The straight-line method charges the exact same depreciation amount every year. The reducing balance method charges a higher amount in the early years and less in later years.
Can I change my depreciation method later?
Changing accounting methods usually requires formal justification and consistency checks, so it is best to consult your accountant before making changes.
Does this affect my bank balance?
No. Depreciation is a non-cash accounting entry. It reduces your profit on paper to reflect asset wear and tear, but it does not involve cash leaving your bank account.