What Is Depreciation?
Depreciation spreads the cost of an asset over its useful life. Learn how it affects your profit and tax.
Key Takeaways
- Depreciation allocates the cost of an asset over the years it provides value
- It reduces profit on the P&L but does not involve a cash outflow
- Straight-line depreciation deducts the same amount each year
- HMRC uses capital allowances rather than accounting depreciation for tax purposes
Why depreciation exists
When you buy equipment for £10,000, you do not get a £10,000 hit to profit in year one — that would be misleading. Instead, accounting rules require you to spread the cost over the useful life of the asset. If the equipment lasts five years, you charge £2,000 per year to the P&L. That annual charge is depreciation.
Straight-line vs reducing balance
Straight-line depreciates the same amount each year: cost minus residual value, divided by useful life. Reducing balance applies a fixed percentage to the remaining book value each year, front-loading the depreciation — better for assets like vehicles that lose value fastest in early years.
Non-cash nature
Depreciation is a non-cash charge. When you record £2,000 of depreciation, no money leaves your bank account. The cash went out when you bought the asset. Depreciation is simply an accounting entry matching the cost to the periods that benefit. This is why EBITDA is often used as a proxy for operating cash generation.
Amortisation
Amortisation is depreciation applied to intangible assets — patents, trademarks, software licenses, goodwill from an acquisition. The mechanics are identical: spread the cost over the useful life.
Tax and capital allowances
HMRC does not accept accounting depreciation as a deductible expense. Instead, they use capital allowances. The Annual Investment Allowance (AIA) lets businesses deduct 100% of qualifying capital expenditure up to a threshold (currently £1 million per year) in the year of purchase.