Depreciation Methods Explained

Depreciation spreads the cost of a tangible fixed asset over its useful life. The method chosen affects how much expense is recognised each year, which in turn affects reported profit and the carrying value of assets on the balance sheet. Under FRS 102 , the depreciation method must reflect the pattern in which the asset’s economic benefits are consumed.

This article covers the three main methods used by UK businesses, with worked examples and guidance on when each is appropriate.

Straight-Line Method

The straight-line method is the most widely used approach 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

Worked Example

A company purchases office furniture for £12,000 with an estimated residual value of £2,000 and a useful life of five years.

Annual depreciation = (£12,000 - £2,000) / 5 = £2,000 per year

The closing net book value (NBV) at the end of year five equals the residual value.

When to Use Straight-Line

Straight-line depreciation is appropriate when the asset provides a roughly equal benefit each year. Common examples include:

• Office furniture and fittings
• Buildings (excluding land, which is not depreciated)
• Leasehold improvements (depreciated over the shorter of the lease term and useful life)

Reducing Balance Method

The reducing balance method (also called the diminishing balance method) applies a fixed percentage to the asset’s carrying value each year. This produces higher depreciation in the early years and lower charges later.

Annual depreciation = Carrying value x Depreciation rate

Worked Example

A delivery van costs £25,000 with an expected residual value of £4,000 and a depreciation rate of 30%.

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

Calculating the Depreciation Rate

If you know the cost, residual value and useful life, the rate can be calculated:

Rate = 1 - (Residual value / Cost) ^ (1 / Useful life)

For the van above: 1 - (4,000 / 25,000) ^ (1/5) = approximately 30%.

When to Use Reducing Balance

This method suits assets that lose value more rapidly in their early years:

• Motor vehicles that depreciate heavily in the first year
• Computer equipment that becomes obsolete quickly
• Technology assets where the majority of benefit is extracted early

Units of Production Method

The units of production method bases depreciation on the asset’s actual usage rather than the passage of time. The charge varies each year depending on output.

Depreciation = (Cost - Residual value) x (Actual output / Total estimated output)

Worked Example

A manufacturing machine costs £150,000 with no residual value and an estimated total output of 500,000 units.

When to Use Units of Production

This method is most appropriate when asset wear is driven by usage rather than time:

• Manufacturing machinery where output varies year to year
• Quarry and mining equipment measured by tonnes extracted
• Printing presses measured by impressions or pages
• Aircraft engines measured by flight hours

Comparison of Methods

Impact on Reported Profit

The method chosen affects reported profit, particularly in the early years of an asset’s life:

A company using the reducing balance method reports lower profit in the early years but higher profit later, even though the total depreciation over the asset’s life is the same.

FRS 102 Requirements

FRS 102 Section 17 sets out the requirements for depreciation of property, plant and equipment:

• The method must reflect the pattern of consumption of the asset’s economic benefits
• The useful life and residual value must be reviewed at least at each reporting date
• Changes in estimates are applied prospectively (the remaining carrying value is spread over the revised remaining life)
• Each significant component of an asset with a different useful life must be depreciated separately
• Land is not depreciated; buildings are

Changing the Depreciation Method

If evidence suggests that the pattern of benefit has changed, the depreciation method should be revised. Under FRS 102, this is treated as a change in accounting estimate, not a change in accounting policy. The new method is applied prospectively from the date of the change.

Depreciation and Tax

HMRC does not allow accounting depreciation as a deductible expense for tax purposes. Instead, businesses claim capital allowances , which are statutory reliefs that replace depreciation in the tax computation.

The difference between accounting depreciation and tax capital allowances creates a timing difference that gives rise to deferred tax under FRS 102 Section 29.

Practical Considerations

Capitalisation Threshold

Most UK businesses set a materiality threshold (typically £500 to £1,000) below which items are expensed immediately rather than capitalised and depreciated.

Part-Year Depreciation

Companies must decide how to handle assets acquired or disposed of part-way through a year. Common approaches include:

• Full month’s charge in the month of acquisition, none in the month of disposal
• Pro-rata based on the exact number of days
• Full year in year of acquisition, none in year of disposal (or vice versa)

The chosen approach should be applied consistently and disclosed in the accounting policies.

Fixed Asset Register

A fixed asset register records every capitalised asset, its cost, depreciation method, accumulated depreciation and carrying value. This register underpins the balance sheet figures and is reviewed during the annual audit.