Depreciation: What It Is, Why It Matters and How It Works

6 days ago
3 min read

Depreciation is one of those accounting terms that sounds far more complicated than it actually is.

It tends to appear quietly in your accounts, often without much explanation, and can leave business owners wondering:

👉 “I bought that last year… so why is it still showing up now?”

👉 “Why is my profit lower when I haven’t spent anything recently?”

Let’s break down what depreciation is, why it exists, and how it works in real life.

What is depreciation?

In simple terms, depreciation is how we spread the cost of an asset over its useful life. Instead of taking the full cost in one go, accounting gradually recognises that cost over time.

A simple analogy

Imagine you buy a pair of work shoes for £100. You don’t wear them once and throw them away. You use them every day for a year so the “cost” of those shoes really belongs across that whole year, not just the day you bought them. Depreciation works in exactly the same way.

What counts as an asset?

Depreciation applies to things your business buys that:

Last more than one year
Are used in the business

Examples

Laptops and computers
Vans and vehicles
Machinery and tools
Office furniture
Equipment

These aren’t treated as day-to-day expenses because they’re assets.

Why don’t we just expense it all at once?

Good question and one of the most common misunderstandings. If you bought a £2,000 laptop and put it all as an expense in one month:

That month’s profit would look very low
The following months would look artificially high
Your accounts wouldn’t reflect reality

Depreciation smooths this out. It matches the cost of the asset to the period it’s actually used.

How does depreciation work?

When you buy an asset:

It goes on your balance sheet (not as an expense)
Each year, a portion of its cost is moved to your Profit & Loss
This continues over its useful life

Example: Laptop

Cost: £1,200
Useful life: 3 years

Using straight-line depreciation: £1,200 ÷ 3 = £400 per year

Year 1 → £400 expense
Year 2 → £400 expense
Year 3 → £400 expense

Instead of one big hit, the cost is spread evenly.

Different methods of depreciation

There are a couple of common approaches:

1. Straight line (most common)

Same amount each year. Simple. Predictable. Widely used.

2. Reducing balance

Higher depreciation in early years, lower later. Often used for:

Vehicles
Equipment that loses value quickly

Example

A van might lose more value in the first year than in later years so this method reflects that.

What about “useful life”?

This is an estimate of how long the asset will be used. Typical examples:

Laptop → 3 years
Office furniture → 5–10 years
Vehicles → 3–5 years

It’s not exact but it’s a reasonable estimate.

The tax bit (this is important)

Here’s where confusion often comes in. Depreciation reduces your profit in your accounts but it is not usually allowed for tax purposes. Instead, HMRC uses something called Capital allowances.

What does that mean? You might show depreciation in your accounts but claim a different amount for tax. Often, you can claim the full cost (via Annual Investment Allowance) even though your accounts spread the cost

Example for a Laptop:

Accounts → £400 per year depreciation
Tax → possibly £1,200 claimed in year one

This is why your accountant adjusts things behind the scenes.

Common misunderstandings

❌ “I paid for it, so it’s all an expense now”

Not in accounting terms, it’s spread over time.

❌ “Depreciation means I’m paying again”

No, it’s just recognising the cost gradually, not paying twice.

❌ “It’s cash leaving the business”

No cash is involved. It’s an accounting adjustment.

❌ “It doesn’t matter”

It does because it affects your profit and how your accounts are interpreted.

Why depreciation matters

Depreciation helps:

✔ Give a more accurate profit figure

So your accounts reflect real business performance.

✔ Spread costs fairly

Matching expenses to the periods they relate to.

✔ Improve decision making

You can see the true cost of running your business.

✔ Keep accounts compliant

It’s part of standard accounting practice.

A quick real-world scenario

You buy a £10,000 van. If you expense it all at once:

Year 1 profit looks very low
Future years look artificially high

With depreciation:

The cost is spread
Profit looks more consistent
Accounts make more sense

Final thoughts

Depreciation isn’t about making things complicated. It’s about making your numbers more accurate. It answers a simple question“How much of this asset have I used this year?” Once you understand that, it becomes much less mysterious. Yes, there are technical bits behind the scenes (and your accountant will handle those) but at its core, depreciation is just "Spreading the cost of something over the time you use it" and in business, that’s a pretty sensible way of looking at things.