Accounting

What is Depreciation?

Depreciation is the accounting method of spreading the cost of a long-term asset over its useful life. It reduces your profit each year.

Current Rate (2025/26)

N/A - varies by asset type and policy

Example

Buy a £10k vehicle with 5-year life. Depreciate £2k/year, reducing profit by £2k annually.

Key Dates

Calculated at year end; note: tax relief uses capital allowances, not depreciation

How Depreciation Works in Practice

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.

Step by Step

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.

Practical Tips

Maintain a fixed asset register listing every capitalised asset, its cost, depreciation method, useful life, and accumulated depreciation
Set a capitalisation threshold (commonly £500 or £1,000) below which items are expensed immediately rather than depreciated
Review your depreciation policy annually -- if assets are consistently being disposed of before or after their estimated useful life, adjust the estimates
Remember that for tax purposes, capital allowances matter more than depreciation -- claim the full AIA on qualifying purchases to accelerate tax relief

Common Mistakes to Avoid

Thinking depreciation is a tax deduction -- it is not; capital allowances replace depreciation for Corporation Tax purposes
Choosing an unrealistically long useful life to reduce the annual depreciation charge, which overstates asset values on the balance sheet
Forgetting to depreciate assets, especially smaller items that are capitalised rather than expensed
Not reviewing useful life estimates periodically -- if an asset will not last as long as estimated, the depreciation rate should be revised

Frequently Asked Questions

Is depreciation a tax-deductible expense?

No. Depreciation is added back in the Corporation Tax computation and replaced by capital allowances. HMRC has its own rules for tax deductions on assets. The Annual Investment Allowance allows 100% deduction on up to £1 million of qualifying plant and machinery in the year of purchase.

What useful life should I use for different assets?

Common useful lives are: computer equipment 3-5 years, office furniture 5-10 years, vehicles 4-6 years, fixtures and fittings 5-10 years, buildings 25-50 years. Your accountant can advise on appropriate lives for your specific assets based on your company's depreciation policy.

What is the difference between depreciation and amortisation?

Depreciation applies to tangible assets (physical items like equipment and vehicles). Amortisation applies to intangible assets (non-physical items like software, patents, and goodwill). The concept is the same -- spreading the cost over the useful life -- but the terminology differs by asset type.

Does depreciation affect cash flow?

No. Depreciation is a non-cash expense. The cash was spent when you bought the asset. Depreciation reduces reported profit without affecting bank balances. This is why it is added back in cash flow statements to reconcile profit to actual cash movement.

Can I depreciate assets below their residual value?

No. Depreciation stops when the carrying value reaches the estimated residual value (or zero if no residual value is expected). If you revise the residual value estimate, adjust future depreciation accordingly.

Source: HMRC Capital Allowances Manual: https://www.gov.uk/hmrc-internal-manuals/capital-allowances-manual

Related Terms

Capital Allowances

Capital allowances let you deduct the cost of business assets (equipment, vehicles, machinery) from your profits before calculating tax.

Amortisation

Amortisation is like depreciation but for intangible assets (software, patents, goodwill). It spreads the cost over the asset's useful life.

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