How mid-sized companies can use the reducing balance method to optimize depreciation and financial planning
Many businesses default to the simple straight-line method, although the reducing balance method offers a more dynamic and realistic approach. We’ll discuss some of the factors to consider when choosing a depreciation method helping you to optimise depreciation for better cash performance.
What is the reducing balance method (reducing balance basis depreciation)?
The reducing balance method, also known as reducing balance basis depreciation, is a type of accelerated depreciation used in accounting whereby a fixed percentage rate is applied to the book value of an asset each year.
Hence it is also often called diminishing balance method or the declining balance method.
The fixed percentage of the asset's net book value (NBV) that is written off every year thus results in higher depreciation charges in the early years of an asset's life and lower charges as it ages.
Why is this method popular? Simply because it matches the higher depreciation expense with periods of higher productivity, when the asset is most productive and loses value most quickly. Depreciation can therefore run through the Profit and Loss statement more realistically, reflecting intensive use and the asset’s key value contribution.
This approach is particularly suitable for assets like vehicles or technology, which experience significant value loss upfront.
Reducing balance method of calculating depreciation: Formula & example
The depreciation formula for this method is straightforward. You calculate the annual depreciation expense by depreciating the asset's net book value (the value at the start of the accounting period) with a fixed rate.
The depreciation formula
Depreciation expense = Net book value (NBV) x Depreciation rate (%)
Net book value (NBV): Assets purchasing cost minus the sum of depreciation from previous periods.
Depreciation rate (%): Fixed percentage based on the asset's useful life.
Step-by-step reducing balance depreciation example
Let's use an example with a residual value. A manufacturing company buys a new piece of machinery for $12,000. The asset has a useful life of 5 years, a depreciation rate of 40%, and an expected residual (or salvage) value of $2,000.
Here is the calculation:
Year 1: $12,000 (NBV) x 40% = $4,800 depreciation. The new NBV is $7,200.
Year 2: $7,200 (NBV) x 40% = $2,880 depreciation. The new NBV is $4,320.
Year 3: $4,320 (NBV) x 40% = $1,728 depreciation. The new NBV is $2,592.
Year 4: At the start of this year, the NBV is $2,592.
Standard depreciation would reduce the NBV below the $2,000 residual value. Therefore, the depreciation expense is adjusted to hit the residual value exactly (instead of $1,036.8).
Year 5: The book value has reached its residual value, so no further depreciation is charged.
Asset value per year
Year | Net Book Value (Start of Year) | Depreciation Expense | Net Book Value (End of Year) |
|---|---|---|---|
1 | $12,000 | $4,800 | $7,200 |
2 | $7,200 | $2,880 | $4,320 |
3 | $4,320 | $1,728 | $2,592 |
4 | $2,592 | $592 | $2,000 |
5 | $2,000 | $0 | $2,000 |
When should you use the reducing balance method?
The reducing balance method is strategically best for assets that are highly productive or lose significant value at the beginning of their useful life. This allows your financial statements to more accurately reflect the economic reality of the asset.
Best-suited asset types and scenarios include:
IT and tech equipment: Computers, servers, and programs that swiftly become obsolete.
Vehicles and factory equipment: Items facing intense use and steep early depreciation.
High-revenue generators: When assets yield more profit initially, this approach matches costs to income patterns.
The main benefit of the reducing balance method is that it shows an asset’s true value over time. For US tax purposes, this approach aligns well with the IRS’s Modified Accelerated Cost Recovery System (MACRS), potentially leading to greater depreciation expense – and thus lower taxable income – in the early years of an asset’s life.
Difference between reducing balance method and straight line method
Picking between reducing balance and straight-line methods depends on the asset and your financial strategy. Though straight-line is easier, the difference matters for precise financial statements.
Feature | Reducing Balance Method | Straight-Line Method |
|---|---|---|
Calculation Basis | Fixed percentage of the declining book value | (Cost - Residual Value) / Useful Life |
Depreciation Charge | Higher in early years, decreases annually | The same amount is charged every year |
Best For | Assets losing value quickly (vehicles, tech) | Assets with steady value (furniture, fixtures) |
Cash Flow Impact | Can result in lower tax bills upfront, improving short-term cash flow | Predictable, stable tax impact each year |
To choose the right approach, consider the asset’s usage pattern. If its economic benefits are consumed more quickly in the early years, the reducing balance method may be more appropriate. Under US accounting standards set by the Financial Accounting Standards Board (FASB), and for tax purposes using MACRS, this method aligns depreciation expense with actual asset usage.
Impact of the reducing balance method on cash flow management and planning
While depreciation is a non-cash expense and does not affect your immediate cash flow, it may still have an impact on cash management by lowering your net profit on your P&L, as a higher depreciation charge reduces your corporation tax liability (depending on individual tax treatment and capital allowances).
For businesses with multiple entities or large asset portfolios, it is imperative to properly track those non-cash charges. Fragmented spreadsheets across multiple entities and manual calculations create blind spots in your cash flow forecast — here is where modern cash flow tools provide critical support.
Agicap helps by:
Automating cash flow forecasting: link your accounting data to see the real-time effect of depreciation on tax payments and cash position.
Enabling effective scenario planning: model the purchase of new assets and see how different depreciation methods would affect liquidity and cash-flow in the future.
Providing visual insights: consolidated, group-level view of asset-related finances and key performance indicators, ending the need of multiple data silos and improving strategic decision-making.
A practical example — how Agicap simplifies depreciation tracking and financial forecasts
Picture a medium-sized UK factory business. Its finance team spent days each quarter manually fixing asset depreciation lists in Excel. Merging this info across three subsidiary entities for a complete picture was lengthy and mistake-prone, making reliable cash predictions almost unfeasible.
After implementing Agicap, the process became automated. By linking their ERP and bookkeeping tools, depreciation math now feeds straight into live, unified cash projections.
Their CFO can swiftly plan scenarios to grasp the cash effect of buying new machines versus renting them, showing clear, fact-based advice to executives.
Take the next step in depreciation and cash flow planning
End the spreadsheet chaos and gain full control and insights over your company's financial flows. Find out how Agicap’s all-in-one treasury management platform simplifies depreciation planning and saves your finance team valuable time to focus on strategic initiatives.
See how Agicap automates your forecasts —book a personalized demo of Agicap today.
FAQ - Reducing balance method questions and answers
What is the formula for the reducing balance method?
The calculation is simple: multiplying the carrying value of an asset (Net book value) by a consistent annual percentage (depreciation rate) to determine periodic depreciation charges.
What does 25% reducing balance mean?
A 25% reducing balance means that each year, the asset is depreciated by 25% of its net book value at the start of the year, not of the original cost. This leads to larger depreciation expenses in the early years and smaller ones as the asset ages.
How is the reducing balance method used for loans?
In loan repayments, the reducing balance method calculates interest only on the outstanding principal, not the initial amount. This means your interest payments decrease over time as you repay the loan.
Why is the reducing balance method considered better?
It is considered better for certain assets because it matches higher depreciation to periods when assets are most productive or lose value fastest. This approach can provide a more realistic view of expenses and potential tax benefits upfront.
How do you calculate straight line depreciation?
Straight line depreciation divides the difference between the asset’s cost and its residual value evenly over its useful life. This results in a fixed yearly depreciation expense.
What is the reducing balance method also called?
The reducing balance method is also known as diminishing balance or declining balance depreciation. These terms all refer to the same principle of applying a fixed rate of depreciation to the asset’s decreasing book value.
How can cash flow tools like Agicap help with depreciation planning?
Cash flow management platforms like Agicap automate projections regarding the impact of depreciation. They help with real-time transparency into how different depreciation scenarios affect financial obligations and future cash reserves, facilitating precise and strategic financial management.
