Depreciation Explained: What It Means for Your Company Accounts

The core concept: matching cost to benefit

When your company buys a piece of machinery for £60,000, the cash has left the business immediately, but the asset will be used — and will generate value — over perhaps five or ten years. Charging the entire £60,000 as a cost in year one would distort that year's profit severely and understate profit in every subsequent year. Depreciation solves this by spreading the cost over the asset's useful economic life.

Each year, a portion of the original cost is charged as a depreciation expense in the P&L. Over time, the accumulated depreciation on the balance sheet increases, and the asset's net book value falls accordingly. When the asset is eventually sold or scrapped, any difference between net book value and sale proceeds is treated as a profit or loss on disposal.

Straight-line vs reducing balance depreciation

The straight-line method charges the same amount each year: cost less estimated residual value, divided by useful life in years. It is simple, predictable, and widely used for buildings, fixtures and office equipment. If the machinery above has no residual value and a five-year life, the annual charge is £12,000.

The reducing balance method applies a fixed percentage to the net book value each year — so the charge is higher in early years and falls over time. This better reflects the pattern of many assets, such as vehicles or IT equipment, which lose value quickly at first. A 25% reducing balance on the same £60,000 asset produces a first-year charge of £15,000, a second-year charge of £11,250, and so on.

Depreciation and cash: the critical distinction

Depreciation reduces reported profit but involves no cash payment. The cash was spent when the asset was purchased; the depreciation charge merely allocates that historic cost across accounting periods. This is why depreciation is added back when moving from operating profit to operating cash flow in the cash flow statement.

This distinction matters for directors assessing whether the business can service debt. A company with high depreciation charges (and therefore lower reported profit) may still generate strong cash flow — a nuance that is easy to miss when reading only the P&L.

Accounting depreciation versus capital allowances

For corporation tax purposes, HMRC does not use the depreciation figure in your accounts. Instead, it grants capital allowances — principally the Annual Investment Allowance (AIA) and Writing Down Allowances — at rates it sets independently. In many cases these differ substantially from accounting depreciation, creating a timing difference that shows up as deferred tax on the balance sheet.

The practical implication: a director cannot read the tax charge in the accounts and assume it equals depreciation times the corporation tax rate. Your accountant will reconcile the two treatments in the tax computation. Always confirm the capital allowances position with your accountant before making significant asset purchases.