When a business buys a piece of equipment, a vehicle, or any other long-term asset, that cost doesn’t hit the income statement all at once. It would distort the financials completely — one terrible month followed by years of apparent profitability with no corresponding cost. Instead, accounting spreads the cost of the asset across its useful life through a process called depreciation. But how that cost is spread matters enormously, and the method you choose affects your profit figures, your tax position, and the carrying value of your assets on the balance sheet every single year.
What Is Depreciation?
Depreciation is the systematic allocation of the cost of a tangible fixed asset over its expected useful life. It recognises that assets wear out, become obsolete, or lose value over time — and it matches that loss of value to the accounting periods in which the asset is being used to generate income. This is the matching principle at work.
When you buy a delivery van for £24,000, you don’t expense £24,000 in year one. Instead, you capitalise it on the balance sheet as a non-current asset and then depreciate it gradually, charging a portion of the cost to the income statement each year as a depreciation expense.
Depreciation is not a cash flow — it’s a non-cash accounting entry. The money left the business when the asset was purchased. Depreciation simply recognises, period by period, that the asset is being consumed in the process of generating revenue.
Two values matter in depreciation calculations: the cost of the asset (what you paid for it) and the residual value (the estimated amount you’ll receive when you dispose of it at the end of its useful life). The difference between these two figures — the depreciable amount — is what you spread over the asset’s useful life.
The Straight-Line Method
The straight-line method is the simplest and most widely used approach. It allocates an equal amount of depreciation in every accounting period across the asset’s useful life. The annual charge never changes — it is the same in year one as it is in the final year.
The formula is straightforward:
Annual depreciation = (Cost − Residual value) ÷ Useful life in years
Using the delivery van example — cost £24,000, residual value £4,000, useful life 4 years:
Annual depreciation = (£24,000 − £4,000) ÷ 4 = £5,000 per year
Each year, £5,000 is charged to the income statement as a depreciation expense, and the net book value (NBV) of the van on the balance sheet falls by £5,000. After four years, the van sits on the balance sheet at its residual value of £4,000 and is fully depreciated.
The straight-line method is favoured for assets that provide roughly equal benefit throughout their lives — office furniture, fixtures and fittings, leasehold improvements, and most plant and machinery fall into this category.
The Reducing Balance Method
The reducing balance method — also called the declining balance method — applies a fixed percentage rate to the asset’s net book value at the start of each period, rather than to its original cost. Because the NBV falls each year, the depreciation charge also falls each year, producing a front-loaded pattern of expense that is heavier in the early years and lighter later on.
The formula is:
Annual depreciation = Net book value at start of period × Depreciation rate %
Using the same van at a 25% reducing balance rate:
- Year 1: £24,000 × 25% = £6,000 depreciation → NBV £18,000
- Year 2: £18,000 × 25% = £4,500 depreciation → NBV £13,500
- Year 3: £13,500 × 25% = £3,375 depreciation → NBV £10,125
- Year 4: £10,125 × 25% = £2,531 depreciation → NBV £7,594
Notice that the reducing balance method never technically reaches zero — or even the residual value — purely through the formula. In practice, businesses either adjust the final year’s charge or switch to straight-line in the last period to bring the asset down to its residual value.
The reducing balance method suits assets that are more productive and more valuable in their early years — vehicles, computers, and technology equipment all tend to lose more of their economic value in the first few years of use than in later years.
Worked Example — Fernwood Interiors Ltd
Fernwood Interiors Ltd purchases a delivery van on 1 January for £24,000. The expected useful life is 4 years and the estimated residual value is £4,000. The table below shows the depreciation charge and net book value under both methods across the full useful life.
| Year | Straight-Line Charge (£) | Straight-Line NBV (£) | Reducing Balance Charge (£) | Reducing Balance NBV (£) |
|---|---|---|---|---|
| Start | — | 24,000 | — | 24,000 |
| Year 1 | 5,000 | 19,000 | 6,000 | 18,000 |
| Year 2 | 5,000 | 14,000 | 4,500 | 13,500 |
| Year 3 | 5,000 | 9,000 | 3,375 | 10,125 |
| Year 4 | 5,000 | 4,000 | 2,531 | 7,594 |
| Total depreciated | 20,000 | 4,000 ✓ | 16,406 | 7,594 |
The straight-line method depreciates the full depreciable amount (£20,000) exactly, landing precisely on the residual value of £4,000. The reducing balance method at 25% has depreciated £16,406 over four years — the van still carries an NBV of £7,594 at year end, above its estimated residual value. Fernwood’s accountant would adjust the rate or the final year’s charge to align the NBV with the expected disposal proceeds.
The key takeaway from this table: reducing balance front-loads the depreciation charge. In years one and two, the income statement carries a higher expense under reducing balance — which lowers reported profit in those early years but results in lower charges later when the asset is older and perhaps more prone to maintenance costs.
Which Method Should You Use?
The choice of depreciation method should reflect how the asset actually loses value and how evenly it contributes to generating revenue over its life. There is no single correct answer — it depends on the type of asset and the accounting standards your business follows.
Under UK GAAP (FRS 102) and IFRS, businesses must apply a depreciation method that reflects the pattern of consumption of the asset’s economic benefits. In practice, most UK SMEs default to straight-line for simplicity, while businesses with significant vehicle fleets or technology assets often use reducing balance to better match the reality of how those assets depreciate in the real world.
For tax purposes in the UK, the rules are different. HMRC does not allow businesses to deduct accounting depreciation as a tax expense. Instead, capital allowances — specifically the Annual Investment Allowance (AIA) and Writing Down Allowances (WDAs) — govern how much of a capital purchase can be deducted for tax. The WDA rates (currently 18% for the main pool and 6% for special rate assets) broadly follow a reducing balance approach. This means your accounting depreciation and your tax relief will rarely match exactly in any given year, creating temporary timing differences on your tax computation. For a full breakdown of how capital and revenue expenditure interact with tax, see our guide on capital vs revenue expenditure.
Once you’ve chosen a method for a class of asset, consistency matters. Switching depreciation methods between periods is permitted under accounting standards but requires disclosure in the financial statements and must be justified as providing more reliable and relevant information. Frequent switches are a red flag for auditors and will raise questions about whether the change is economically justified or cosmetically motivated.
How Depreciation Appears in the Financial Statements
Depreciation touches three of your key financial statements, and understanding where it appears in each is important for reading your accounts accurately.
On the income statement, depreciation appears as an operating expense — usually within administrative expenses or cost of sales, depending on the nature of the asset. It reduces your operating profit and your net profit for the period.
On the balance sheet, fixed assets are shown at cost less accumulated depreciation — that figure is the net book value. The longer you’ve held an asset and the faster it depreciates, the lower its NBV relative to its original cost. See our guide to understanding the balance sheet for how non-current assets are presented.
On the cash flow statement (indirect method), depreciation is added back to operating profit in the reconciliation section. Because it is a non-cash charge — no money actually left the business in the period — it must be reversed out of profit to arrive at the true cash generated from operations.
Key Takeaways
- Depreciation spreads the cost of a fixed asset across its useful life, matching the expense to the periods in which the asset generates income.
- The straight-line method charges an equal amount each year — simple, predictable, and suited to assets that provide even benefit over time.
- The reducing balance method charges a fixed percentage on the declining net book value — front-loading the expense and better reflecting how some assets (vehicles, technology) lose value rapidly in early years.
- The choice of method should reflect how the asset is actually consumed, not what produces the most convenient profit figure.
- Depreciation is a non-cash item — it reduces profit but has no direct impact on your bank balance in the period it is charged.
- For tax purposes in the UK, capital allowances (not accounting depreciation) determine how much of a capital purchase is deductible — these figures will rarely match your accounting charge.
Related reading: If you found this guide useful, you may also want to read our posts on capital vs revenue expenditure, understanding the balance sheet, trial balance explained, and understanding the income statement.
