What is Depreciation?

Depreciation is the accounting process of spreading the cost of a tangible fixed asset (such as equipment, vehicles, furniture, or machinery) over its expected useful life. Instead of recording the full cost as an expense in the year you buy the asset, you record a portion each year. This matches the cost of the asset to the periods in which it generates revenue, following the matching principle in accounting.

There are two common methods of calculating depreciation. Straight-line depreciation divides the cost evenly over the useful life -- a £10,000 asset with a 5-year life depreciates at £2,000 per year. Reducing balance depreciation applies a fixed percentage to the remaining book value each year -- a £10,000 asset at 25% reduces by £2,500 in year one, £1,875 in year two, and so on. Reducing balance front-loads the expense, reflecting that many assets lose more value in their early years.

A crucial point for UK company directors: depreciation is an accounting expense, not a tax deduction. When calculating Corporation Tax, HMRC ignores your depreciation charge and replaces it with capital allowances. Your tax computation adds back the depreciation from the accounts and then deducts capital allowances instead. Capital allowances follow HMRC's own rules about how much you can deduct and when. The Annual Investment Allowance (AIA), currently £1 million, allows 100% first-year deductions for qualifying plant and machinery.

Depreciation affects your reported profit but not your cash flow. It is a non-cash expense -- you already paid for the asset when you bought it. This is why companies can show lower profits due to depreciation while having healthy cash balances, and why depreciation is added back in cash flow statements.

When you purchase a fixed asset, the cost is capitalised on your balance sheet rather than expensed on the P&L. Each year, a depreciation charge is calculated and recorded as an expense on the P&L, reducing the asset's carrying value on the balance sheet by the same amount. The accumulated depreciation builds up until the asset is fully depreciated or disposed of.

To calculate depreciation, you need three things: the cost of the asset, its estimated useful life, and its residual value (what you expect it to be worth at the end of its life). For example, a £15,000 vehicle with a 5-year life and £3,000 residual value would be depreciated at £2,400 per year under straight-line (£12,000 / 5 years).

When you dispose of an asset, you compare the sale proceeds to the carrying value (cost minus accumulated depreciation). If you sell for more than the carrying value, the difference is a profit on disposal. If less, it is a loss on disposal. Both are recorded on the P&L. The capital allowances treatment of the disposal also needs to be calculated separately for the tax computation.