Depreciation is the accounting method used to spread the cost of a physical asset over its useful working life. Instead of recording the full cost of an asset as an expense in the year it was purchased, depreciation allocates that cost across multiple years, reflecting the fact that the asset gradually loses value over time.
| 📊 Example A photographer buys a professional camera for £2,400. Rather than recording a £2,400 cost in year one, they depreciate it over 4 years at £600 per year. Each year, £600 appears as a depreciation charge on the profit and loss account. |
Why Does Depreciation Exist?
Depreciation exists to match costs with the periods they benefit. If you buy a delivery van that you’ll use for 5 years, it wouldn’t make sense to show a huge cost spike in year one and zero asset-related costs in years 2–5. Depreciation smooths this out, giving a more accurate picture of profitability in each year.
This is a core principle of accounting called the matching principle, expenses should be recognised in the same period as the revenue they help generate.
What Assets Can Be Depreciated?
Depreciation applies to tangible fixed assets, physical things your business owns and uses over time. Common examples for UK small businesses include:
- Vehicles (vans, cars, company trucks)
- Equipment and machinery
- Computers and IT hardware
- Fixtures and fittings
- Commercial property (buildings, but not the land itself)
Assets that are not depreciated include: land (it doesn’t wear out), current assets like stock (these are sold, not depreciated), and financial investments.
How is Depreciation Calculated?
The two most common methods used in UK small businesses are:
Straight-Line Depreciation
The asset loses an equal amount of value each year.
| Formula: (Cost − Residual Value) ÷ Useful Life Example: A £10,000 machine with a residual (scrap) value of £1,000 and a 3-year useful life: (£10,000 − £1,000) ÷ 3 = £3,000 depreciation per year. |
Reducing Balance Depreciation
A fixed percentage is applied to the remaining book value each year. This front-loads the depreciation charge, the asset depreciates faster in early years.
| Formula: Book Value × Depreciation Rate % Example: A £10,000 asset depreciated at 25% reducing balance: Year 1: £10,000 × 25% = £2,500 → Book value £7,500 Year 2: £7,500 × 25% = £1,875 → Book value £5,625 |
Depreciation vs Capital Allowances: What’s the Difference?
This is an important distinction for UK tax purposes. Depreciation is an accounting concept used in your financial accounts. HMRC does not accept depreciation as a tax-deductible expense.
Instead, HMRC uses its own system called Capital Allowances, principally the Annual Investment Allowance (AIA), which currently allows businesses to deduct the full cost of qualifying assets (up to £1 million per year) in the year of purchase, for tax purposes.
Your accounts will show depreciation; your tax return will use capital allowances. Your accountant will adjust for this difference in the tax computation.
Frequently Asked Questions
No. Depreciation is a non-cash charge, no money leaves your account when you record it. This is why EBITDA adds depreciation back to get a closer approximation of actual cash generation.
Once an asset reaches zero (or its residual value) in your accounts, no more depreciation is charged. The asset stays on your balance sheet at that residual value until it is sold, scrapped, or written off.
Sole traders’ accounts often use capital allowances rather than formal depreciation, as HMRC doesn’t accept accounting depreciation for tax. However, preparing accounts with depreciation gives a more accurate picture of profitability for management purposes.
