Just like your phone, computer, or car, most things lose value over time. While this loss of value is unavoidable, businesses can harness an asset’s lifetime and depreciative worth to enhance their overall financial health.
This process is called depreciation, and it helps manage both your tax and your asset lifecycles. The Office of Tax Simplification defines it formally as the “systematic writing down of a tangible fixed asset to determine the carrying value of an asset in a business’s financial accounts.” By calculating the cost of an asset over its lifetime, businesses can yield many practical and financial benefits.
Read on and discover these benefits, as well as what qualifies as a depreciable asset, the diverse types of depreciation methods you can use, and how to calculate depreciation.
Key takeaways
- Depreciation spreads out the cost of assets over time.
- There are three main methods you can use to calculate business depreciation.
- In the UK, you can claim the typical benefits of depreciation through capital allowances.
Why does depreciation exist in accounting?
Suppose you have recently started a construction business. To get things moving, you need clients, a workforce, and the tools and equipment to carry out your hard-won contracts. Depending on the project’s size, this could involve purchasing a range of heavy machinery, including diggers, cranes, excavators, and bulldozers.
This also means a large bill for you to foot at the beginning of your company’s lifespan.
- Trivial benefits for limited company directors
- A guide to dividend vouchers for limited companies
- Working from home expenses for limited companies
While these are necessary costs, there are ways to mitigate them. Depreciation is one such useful strategy. By depreciating your assets, you spread their costs over their respective lifetimes. This means that, in your accounting books, the overall cost of an asset is spread out over the years rather than being recorded as a single, exorbitant sum.
Depreciation helps businesses match the cost of using an asset with the revenue it generates, making huge purchases more manageable and carrying certain tax advantages.
The benefits of depreciation accounting
Depreciation does not impact the initial cost of the assets you purchase for your business purposes.
What it does do, however, is offer certain tax and practical bookkeeping benefits, such as:
- Spreading an asset’s incurred cost of tax over several financial years rather than as a single payment charged at a higher rate of tax (in the UK, you claim tax relief through capital allowance).
- Painting a clearer picture of your business’s costs vs profits.
- Projecting clear timelines for when certain assets will need replacing.
How does depreciation in accounting work?
Understanding how depreciation works in accounting is essential for any business. It can become a little complicated, so here’s a breakdown to guide you through the main points.
How depreciation appears on a financial statement
When you purchase an asset, its overall cost is spread across the number of years that you expect it to remain useful. You calculate this as the total cost of the asset divided by its predicted life expectancy.
For instance, if you purchase a £10,000 printer for your magazine business and it has an expected lifespan of 10 years, then your financial statements will list this printer at a cost of £1,000 every year for 10 years, after which you’d expect to replace it.
How it affects taxable profit
Typically, you can calculate taxable profit by working out your overall cash turnover minus your tax-deductible business expenses. When you have a depreciable asset, the cost of this is also negated from your taxable profit, which means more money for your business at the end of every fiscal year.
For instance, if you report an annual turnover of £150,000, but your tax-deductible business expenses equate to £80,000, then £70,000 of your profits will be taxed.
But if you have depreciable assets totalling £30,000, this number adds to your tax-deductible expenses, meaning only £40,000 of your profits will be taxed.
However, the UK government approaches depreciation and tax differently through a system of capital allowance.
Capital allowance
In the UK, the government does not account for depreciable assets as a valid form of tax relief. This means that, in the UK, you don’t deduct depreciation directly from your taxes. Instead, you claim back money lost through depreciation by applying for capital allowance (CA).
There are several forms of capital allowance that you can apply for when filing your annual tax return:
- Annual investment allowance (AIA)
- Writing down allowance (WDA)
- 100% first-year allowances
- The super-deduction and 50% special rate first-year allowance
- Full expensing and 50% first-year allowance
Through these allowances, you can either get a tax refund on 100% of the cost of the asset (covered by an AIA) or have part of its value returned to you year-on-year (covered by a WDA at fixed rates). Capital allowances can be claimed for:
- Equipment
- Machinery
- Business vehicles
- Extracting minerals
- Research and development
- Intellectual property
- Patent rights
- Dredging allowances
- Structures and buildings
- Renovating unused business premises
Depreciation vs devaluation vs expense
While these terms are often used interchangeably, they are different:
- Depreciation refers to an asset losing value due to general wear and tear.
- Devaluation is an economic term that refers to something becoming of lower value, typically due to an unexpected change, such as sudden damage.
- An expense is usually a necessary payment incurred by a business.
Understanding the difference between these terms is essential, as business owners can often confuse the distinction between depreciation and devaluation.
Types of depreciation
Depreciation is a helpful way of managing your books by calculating the annual loss of value for a particular asset up until the end of its useful life. There are three principal ways by which you can measure depreciation in your business accounting:
1. Straight line depreciation
Straight-line depreciation is the most easily understood and recognisable form of depreciation in accounting, which spreads the cost of an asset equally over its expected years of service.
If you bought an industrial loom for £50,000, and it was expected to last for 10 years with good regular maintenance, then its depreciative value year-on-year would be £5,000, or 10%.
Eventually, the value of the loom would reach £0, at which point it would be replaced with a new asset.
2. Reducing balance method
Also known as declining balance depreciation, this method calculates depreciation as a fixed percentage of its remaining book amount rather than its initial cost.
Take the £50,000 industrial loom once more. With a fixed depreciation rate of 10%, it would be worth £45,000 after year 1. After year 2, it would be worth 40,500. Year 3 = 36,450. After 10 years, the loom would still be worth £17,433.92.
Through this method, the asset’s value decreases most dramatically in the first years of its lifespan before lessening over time. This means that the value of depreciation decreases year by year rather than remaining constant.
3. Usage-based or units-of-production method
This method calculates depreciation based on the asset’s actual output rather than applying fixed rates of depreciation. This is useful for gauging depreciation as it is affected by use rather than generalised wear and tear.
This method relies on calculating the specific unit value of the asset. To do this, you need to know the residual value of the asset (what you expect it to be worth at the end of its lifetime) and the estimated units of production (how many units it is likely to produce in its lifetime).
Say you expect the £50,000 loom to be worth £10,000 by the end of its life, and it is designed to produce 100,000 units of clothing over its entire lifetime. You would subtract £10,000 from £50,000 to get £40,000, and then divide this number by 100,000 to get £0.40 per unit.
If the loom makes 15,000 clothes in the first year, then 15,000 x 0.4 = £6,000 (first-year depreciation value).
What depreciation method is right for you?
Use the table below to gauge which depreciation method is best suited for your business needs.
| Depreciation method | Description | Best suited for | Pros | Cons |
|---|---|---|---|---|
| Straight-line method | Asset depreciates evenly over the course of its useful life | Assets with steady wear and tear | Simple to use, easy to apply | Doesn’t reflect actual wear and tear |
| Reducing balance method | Asset depreciates at a fixed % rate of the remaining yearly book value | Assets that lose value quickly (cars, tech) | Matches real-world depreciation for many assets | Never fully depreciates to 0 |
| Usage-based units-of-production method | Asset depreciated based on usage/output | Machinery or equipment whose value is determined by usage | Matches cost to output, which is the most accurate method for variable use | Requires detailed usage tracking and estimation |
How to manage depreciation in your business: A step-by-step guide
Smaller businesses can substantially benefit from depreciation methods. Whether you are just beginning your entrepreneurial journey or you have been in operation for a few years, anyone can profit from learning depreciation as an accounting technique to help bolster your finances and gain crucial asset and financial management skills.
Get started with depreciation accounting by following this short guide:
1. Make a list of your business assets
Identify all the tangible items your business possesses that are used in your operations, have a lifespan of more than two years, and are not consumed within the company.
2. Determine which assets qualify for capital allowances
Now identify which of these assets are depreciable and covered by the UK government’s capital allowance scheme using the list provided by gov.uk.
3. Calculate the depreciative value of each asset
Using any of the three main depreciation accounting methods above, calculate the depreciative value of each of your assets and record them in your books.
4. Decide which capital allowance best suits you
If you want to get tax relief from your business assets straight away, consider choosing an AIA. If you want to gain fixed tax relief from your assets over a long-term timespan, consider selecting a WDA instead.
5. Record your capital allowances claims in your tax computation
Make sure to keep detailed bookkeeping on all the assets you have calculated depreciation for and are claiming relief through capital allowances.
6. Claim capital allowances on your business tax return
Complete your business’s tax return and claim capital allowance for the assets that are eligible for tax relief. HMRC may request evidence, so ensure that your bookkeeping is up to date and accurate.
Ready to manage your finances smarter?
Now you have a deeper and more complete understanding of depreciation accounting and how it can meet your business needs.
Still unsure which depreciation method to use or how to claim capital allowances? Our team can help you get set up smoothly – contact us for expert guidance, or start your business with Rapid Formations today.
Frequently asked questions
Please note that the information provided in this article is for general informational purposes only and does not constitute legal, tax, or professional advice. While our aim is that the content is accurate and up to date, it should not be relied upon as a substitute for tailored advice from qualified professionals. We strongly recommend that you seek independent legal and tax advice specific to your circumstances before acting on any information contained in this article. We accept no responsibility or liability for any loss or damage that may result from your reliance on the information provided in this article. Use of the information contained in this article is entirely at your own risk.
Join The Discussion