What is Depreciation?

Depreciation is the systematic allocation of the cost of a tangible fixed asset over its estimated useful life. It reflects the fact that assets such as machinery, vehicles and buildings lose value over time through wear and tear, obsolescence or the passage of time. Depreciation is an expense on the income statement and reduces the carrying value of the asset on the balance sheet .

Section 1: Why Depreciation Matters

1.1 The Matching Principle

Depreciation exists because of the matching principle . When a business buys a machine for £100,000 and expects it to generate revenue for ten years, charging the full £100,000 as an expense in year one would distort the accounts. Instead, the cost is spread over the asset’s useful life so that each period bears its fair share of the cost.

1.2 True and Fair View

Under the Companies Act 2006, financial statements must give a true and fair view. Without depreciation, fixed assets would be shown at their original cost indefinitely, overstating the balance sheet and understating expenses.

1.3 Non-Cash Expense

Depreciation is a non-cash expense. No money leaves the business when depreciation is recorded. This is why it is added back when preparing the cash flow statement under the indirect method.

Section 2: Key Terms

Section 3: Depreciation Methods

3.1 Straight-Line Method

The most widely used method in the UK. It allocates an equal amount of depreciation to each year of the asset’s useful life.

Annual depreciation = (Cost - Residual value) / Useful life

Example: A delivery van costs £30,000, has a residual value of £5,000 and a useful life of five years.

Annual depreciation = (£30,000 - £5,000) / 5 = £5,000 per year

3.2 Reducing Balance Method

Also known as the diminishing balance method. It applies a fixed percentage to the carrying value each year, producing higher depreciation in early years and lower depreciation later.

Annual depreciation = Carrying value x Depreciation rate

Example: The same van at a 40% reducing balance rate.

*In practice, the final year’s charge is adjusted to bring the carrying value to the residual value.

This method is appropriate for assets that lose value more quickly in their early years, such as vehicles and computer equipment.

3.3 Units of Production Method

Depreciation is based on the asset’s actual usage rather than the passage of time.

Depreciation = (Cost - Residual value) x (Units produced in period / Total estimated units)

Example: A printing press costs £200,000, has no residual value and is expected to print 2 million pages over its life. In year one it prints 500,000 pages.

Year 1 depreciation = £200,000 x (500,000 / 2,000,000) = £50,000

This method is used in manufacturing and industries where asset wear is driven by output rather than time.

Section 4: FRS 102 Requirements

4.1 Recognition

FRS 102 Section 17 states that the cost of an item of property, plant and equipment shall be recognised as an asset if:

• It is probable that future economic benefits associated with the item will flow to the entity
• The cost can be measured reliably

4.2 Measurement After Recognition

FRS 102 allows two models:

• Cost model: Cost less accumulated depreciation and impairment losses (most commonly used)
• Revaluation model: Fair value less subsequent accumulated depreciation and impairment

4.3 Depreciation Requirements

FRS 102 requires:

• Each significant part of an asset with a different useful life is depreciated separately (component depreciation)
• The depreciation method reflects the pattern in which the asset’s future economic benefits are expected to be consumed
• The useful life and residual value are reviewed at least at each reporting date and revised if expectations differ from previous estimates
• Depreciation begins when the asset is available for use and ceases when it is derecognised or classified as held for sale

4.4 Useful Life Estimates

FRS 102 does not prescribe specific useful lives. Typical ranges used by UK businesses include:

Section 5: Depreciation and UK Tax

5.1 Capital Allowances

For corporation tax and income tax purposes, HMRC does not allow accounting depreciation as a deductible expense. Instead, businesses claim capital allowances, which are statutory tax reliefs that replace depreciation.

The depreciation charge is added back to accounting profit, and capital allowances are deducted to arrive at taxable profit.

5.2 Key Capital Allowance Rates

The Annual Investment Allowance of £1 million means that most small and medium-sized businesses can deduct the full cost of qualifying assets in the year of purchase, making capital allowances more generous than accounting depreciation.

5.3 Deferred Tax

The difference between accounting depreciation and tax capital allowances creates a timing difference that gives rise to deferred tax. Under FRS 102 Section 29, deferred tax is recognised on all timing differences at the balance sheet date.

For more on how financial and tax accounting interact, see our article on UK accounting standards .

Section 6: Impairment

6.1 What is Impairment?

An asset is impaired when its carrying value exceeds its recoverable amount (the higher of fair value less costs to sell and value in use). Impairment is separate from depreciation and represents an unexpected loss in value.

6.2 When to Test for Impairment

FRS 102 Section 27 requires an impairment review when there are indicators that an asset may be impaired, such as:

• Significant decline in market value
• Adverse changes in technology or markets
• Physical damage
• Underperformance relative to expectations

6.3 Recording Impairment

An impairment loss is charged to the income statement and reduces the carrying value of the asset. Subsequent depreciation is recalculated based on the revised carrying value.

Section 7: Disposal of Depreciated Assets

When a fixed asset is sold or scrapped, the business must:

1. Remove the asset’s cost and accumulated depreciation from the balance sheet
2. Record any proceeds received
3. Recognise a profit or loss on disposal in the income statement

Example: Equipment with a cost of £20,000 and accumulated depreciation of £15,000 (carrying value £5,000) is sold for £7,000.

• Profit on disposal = £7,000 - £5,000 = £2,000

For assets sold at less than carrying value, a loss is recorded. This reinforces why accurate depreciation estimates matter: if an asset is consistently sold for significantly more or less than its carrying value, the useful life or residual value estimates may need revising.

Section 8: Depreciation vs Amortisation

Both depreciation and amortisation allocate the cost of an asset over its useful life. The key distinction:

Section 9: Practical Considerations

9.1 Capitalisation Threshold

Most UK businesses set a materiality threshold below which items are expensed rather than capitalised and depreciated. A typical threshold is £500 to £1,000.

9.2 Review of Estimates

Directors should review useful lives and residual values annually. Changes in estimates are applied prospectively under FRS 102, meaning the remaining carrying value is spread over the revised remaining useful life.

9.3 Fixed Asset Register

A fixed asset register tracks every capitalised asset, its cost, depreciation method, accumulated depreciation and carrying value. This register supports the balance sheet and is essential for the trial balance and audit process.

Understanding depreciation is fundamental to interpreting UK financial statements accurately and forms a core part of accounting principles .