Under straight line depreciation, a business recognizes an equal amount of depreciation expense for every year an asset is in service. The reducing balance method -- also known as the declining balance method, double declining balance method or the accelerated method -- front-loads more depreciation into the first years of an asset's life. This works well if the business wants a larger immediate tax deduction, but it reduces depreciation tax breaks for subsequent years.
Under the reducing balance method, the asset is depreciated at a higher percentage rate than it would be under straight line depreciation. To calculate depreciation under the reducing balance method, follow these steps:
- Calculate the straight line depreciation percentage based on useful life and multiply it by two. For example, if an asset has a useful life of 10 years, it would be depreciated at 10 percent a year under straight line and 20 percent a year under double declining balance.
- Multiply the book value of the asset by the double declining percentage to find depreciation expense. For example, if the asset is worth $5,000, depreciation would be 20 percent of $5,000, or $1,000.
- Subtract accumulated depreciation from the asset's original value to find current book value. In this example, the new current book value is $5,000 less $1,000, or $4,000.
- For the subsequent year, multiply the new book value by the double declining balance rate to find that year's depreciation. In our example, that would be 20 percent of $4,000, or $800.
- Repeat until the asset is fully depreciated.
The major advantage of the reducing balance method is the tax benefit. Under the reducing method, the business is able to claim a larger depreciation tax deduction earlier on. Most businesses would rather receive their tax break sooner rather than later. From a financial accounting perspective, the reducing balance method makes sense for assets that lose their value quickly, like new cars and other vehicles. For these assets, reducing balance depreciation better matches depreciation expense with the actual decline in fair market value.
There are some tax scenarios in which a company may not want a bigger tax break early on. If the company already has a tax loss for the year, it won't benefit from an extra tax deduction. Spreading out the deduction evenly can help businesses ensure they don't face sky-high tax bills in later years. For assets that don't lose their value quickly, like equipment and machinery, an accelerated depreciation method doesn't make logical sense. It may be more accurate to depreciate these assets based how much they're used -- like the units of production method does -- rather than with the reducing balance method.