What is depreciation?
Depreciation is the accounting charge that spreads the cost of a long-term asset, such as equipment or a van, over the years it is used.
What depreciation means
When a business buys something it will use for several years, such as a laptop, machinery or a vehicle, it does not record the whole cost as an expense in the year of purchase. Instead the item goes on the balance sheet as a fixed asset, and a portion of its cost is charged to the profit and loss account each year. That annual charge is depreciation.
The aim is to match the cost of the asset against the income it helps to earn. Physical assets are depreciated; intangible ones, such as software licences or purchased goodwill, are handled the same way under the name amortisation.
The two common methods
- Straight line: the same amount every year. Cost less expected resale value, divided by useful life.
- Reducing balance: a fixed percentage of the remaining value each year, so the charge is highest early on. It suits assets like vehicles that lose value fastest when new.
Example
A bakery buys an oven for £12,000. It expects to use it for five years and sell it for £2,000 at the end.
| Year | Straight-line charge | Value at year end |
|---|---|---|
| 1 | £2,000 | £10,000 |
| 2 | £2,000 | £8,000 |
| 3 | £2,000 | £6,000 |
| 4 | £2,000 | £4,000 |
| 5 | £2,000 | £2,000 |
Each year £2,000 reduces profit in the accounts, even though the cash all left the bank in year one.
Why it matters for your business
Depreciation gives a truer picture of profit. Without it, the year you buy equipment would look terrible and later years would look better than they really are. It also shows how much of your asset base is wearing out, which helps you plan for replacements.
Depreciation and UK tax
HMRC does not allow depreciation as a tax deduction. In the tax computation it is added back to profit, and capital allowances are claimed instead. For most small businesses the Annual Investment Allowance gives 100% relief on up to £1 million of qualifying equipment in the year of purchase, so the oven above could be deducted in full for tax in year one, while the accounts still show £2,000 a year.
Common questions
No. Depreciation is added back when working out taxable profit, and capital allowances are claimed in its place. For most equipment the Annual Investment Allowance gives full relief in the year of purchase, which is usually faster than depreciation.
Straight line is simplest and suits assets that are used evenly, such as furniture or office equipment. Reducing balance suits assets that lose value quickly at first, such as vehicles and computers. Pick the method that reflects how the asset is actually used and apply it consistently.