Depreciation: Methods, Accounting Treatment, and the Difference from Capital Allowances

What depreciation is and why it exists

When a company spends £50,000 on a piece of machinery, it does not charge that entire cost to the profit-and-loss account in the year of purchase. Instead, the cost is spread over the asset's useful life — the number of years the company expects to derive economic benefit from it. This is the matching principle: costs are recognised in the periods that benefit from them.

Depreciation is a non-cash accounting charge. It reduces reported profit and the carrying value of the asset on the balance sheet, but no cash leaves the business in the period the charge is made — the cash left when the asset was originally purchased.

Straight-line versus reducing balance

Under the straight-line method, an equal charge is made each year. An asset costing £50,000 with a five-year life and no residual value would be depreciated at £10,000 per annum. The method is straightforward and predictable, which suits assets whose usefulness declines evenly over time.

The reducing balance method applies a fixed percentage to the asset's net book value each year, producing a higher charge in early years and a lower charge later. This better reflects assets — such as commercial vehicles or computers — whose economic benefit is greater in their early years. For example, at 25% reducing balance, a £50,000 asset would be charged £12,500 in year one, £9,375 in year two, and so on.

Depreciation and corporation tax

HMRC does not accept accounting depreciation as a deductible expense for corporation tax purposes. Instead, companies claim capital allowances under HMRC's own rules — primarily the Annual Investment Allowance and writing-down allowances. This creates a timing difference between the depreciation charge in the accounts and the tax relief actually received, which accountants resolve through a deferred tax calculation.

Impairment versus depreciation

Depreciation assumes the asset is being consumed in the normal course of use. If an asset's recoverable amount falls below its net book value for reasons beyond normal use — for example, market value of a property collapses, or a piece of equipment becomes obsolete — an impairment charge must be recognised under FRS 102 or IFRS. Impairment and depreciation may both apply to the same asset in the same period.