Depreciation is the systematic allocation of the cost of a physical asset across its estimated useful economic life. In business accounting, it reflects how equipment, machinery, and vehicles decline in value over time due to wear and tear, operational usage, or obsolescence.
By spreading capital expenditure across the financial periods that benefit from using the asset, depreciation ensures your financial statements give an accurate picture of ongoing profitability. Rather than absorbing an entire capital expense on the day of purchase, your business recognises the cost gradually as the asset helps generate revenue.
What is depreciation?
Under UK accounting rules, including FRS 102 and the Companies Act 2006, fixed assets with limited economic lives are written down systematically over time. When your company purchases a long-term resource, such as commercial machinery or IT hardware, you record that purchase on the balance sheet.
Depreciation applies to tangible assets. In contrast, amortisation is the equivalent accounting mechanism used for intangible assets, such as software licences, copyrights, and patents.
Not all physical assets are depreciated. Freehold land generally has an unlimited useful economic life, meaning it does not suffer from operational decay or wear and tear.
Why depreciation matters for businesses
Depreciation aligns with standard accrual accounting. If you buy a commercial delivery van for business operations, that vehicle will help generate customer deliveries for several years. Expensing the entire vehicle in month one would artificially depress that month's operating profit while overstating profits in subsequent years.
Understanding depreciation helps finance teams avoid several widespread operational and reporting misconceptions:
- Depreciation does not build a cash reserve: Depreciation is an accounting entry that spreads historical acquisition costs across reporting periods. It does not transfer cash into a savings account or guarantee liquid funds to buy replacement assets.
- Carrying value does not equal market value: The net book value of an asset on your balance sheet represents unallocated historical cost, not what a third party would pay on the open market today.
- Depreciation is not tax-deductible in the UK: HMRC does not permit businesses to deduct commercial accounting depreciation when calculating taxable profit. Finance teams must add back depreciation charges in their tax computations and claim statutory capital allowances instead.
In the UK, capital allowances provide statutory tax relief on qualifying capital expenditure. Total capital allowances claimed by UK companies reached £157.2 billion in financial year 2023 to 2024 (HMRC). Qualifying plant and machinery often qualifies for the permanent Annual Investment Allowance, which grants 100% first-year tax relief up to a £1,000,000 threshold per 12-month period (GOV.UK).
Expenditure beyond that threshold enters statutory pools: the main pool receives a 14% annual Writing Down Allowance on a reducing-balance basis from April 2026 (reduced from 18% previously), while special rate assets receive 6% (GOV.UK). When an unallocated pool balance is £1,000 or less before applying the allowance, businesses can claim the entire remaining sum as a small pools allowance (GOV.UK).
Key components: useful life and salvage value
To establish an accurate depreciation schedule, your finance team considers key variables at the time of asset acquisition:
- Initial cost: The asset purchase and capitalisation amount, determined under relevant official accounting standards.
- Useful economic life: The estimated timeframe over which your business expects to extract productive use or economic benefits from the asset.
- Salvage value (residual value): The expected residual value upon disposal, assessed according to official accounting standards.
- Depreciable amount: The total cost base subject to write-down, calculated by deducting estimated salvage value from initial cost.
Finance teams review useful life and salvage value estimates when operational demands or technological shifts change expectations. Any adjustments are applied prospectively across remaining accounting periods without restating prior financial statements.
Common depreciation methods and formulas
Businesses select a depreciation method that aligns with how an asset delivers value over time. The two primary approaches used across UK businesses are straight-line depreciation and reducing balance depreciation.
Straight-line depreciation
Straight-line depreciation spreads the depreciable cost of an asset in equal annual increments across its useful life. It is the most common method because it is transparent, predictable, and suitable for assets that provide steady utility, such as office fixtures and leasehold improvements.
The straight-line depreciation formula is:
Annual Depreciation = (Cost - Salvage Value) / Useful Economic Life
For example, suppose your company buys workshop equipment for £10,000, projects a £1,000 residual value, and estimates a 4-year useful life. The depreciable amount is £9,000, producing an annual depreciation charge of £2,250 each year. At the end of Year 4, the asset has a net book value of exactly £1,000.
Reducing balance depreciation
Reducing balance depreciation applies a constant percentage rate to the asset's remaining carrying value at the start of each accounting period. This approach charges higher depreciation in the early years of ownership and smaller amounts later on.
Finance teams frequently select reducing balance for assets that lose market value quickly or require escalating maintenance costs over time, such as commercial vehicles, specialist plant, and IT hardware.
The reducing balance formula is:
Depreciation Expense = Carrying Value * Depreciation Rate
For example, consider an equipment asset purchased for £10,000 using a 40% depreciation rate and a £1,000 residual value. In Year 1, the depreciation charge is £4,000, leaving a carrying value of £6,000. In Year 2, taking 40% of £6,000 produces an expense of £2,400, bringing the carrying value down to £3,600. In Year 3, the expense is £1,440, leaving a carrying value of £2,160. In Year 4, calculating 40% would breach the target floor, so the charge is restricted to £1,160 to bring the carrying value to the exact £1,000 residual value.
Where depreciation appears in financial statements
Depreciation impacts both primary financial statements through routine double-entry bookkeeping. Each reporting period, your finance team posts a journal in the general ledger:
- Debit: Depreciation Expense on the profit and loss statement, categorised under operating expenses.
- Credit: Accumulated Depreciation on the balance sheet, categorised as a contra-asset account.
Accumulated depreciation offsets the historical cost of your fixed assets, reducing their balance sheet carrying value over time.
Because depreciation does not involve direct cash outflows, management teams and lenders evaluate operational profitability using EBITDA (earnings before interest, taxes, depreciation, and amortisation). Adding back depreciation allows analysts to evaluate core trading performance without distortion from historical capital expenditure timings.