What is depreciation? Methods and how to calculate it

Published Monday 15 June 2026

Table of contents

• What is depreciation?
• What can be depreciated?
• Why depreciation matters for your small business
• How to calculate depreciation
• Understanding salvage value and useful life
• Choosing a depreciation schedule
• Where depreciation appears in your accounts
• Capital allowances and depreciation tax relief in the UK
• Setting up depreciation for your small business
• Simplify your depreciation with Xero
• FAQs on depreciation

Key takeaways

• Depreciation spreads the cost of long-term business assets like equipment, computers and vehicles over their useful life, giving you a more accurate picture of your profits each year.
• HM Revenue and Customs (HMRC) sets capital allowance rates for different asset types, with the main pool writing down allowance (WDA) at 14% and the special rate pool at 6%.
• Choosing the right depreciation method for each asset helps you plan for replacements, manage cash flow and claim the tax relief you're entitled to.
• Reviewing your depreciation schedule at least once a year keeps your asset values accurate and helps you stay on top of any changes to tax rules.

What is depreciation?

Depreciation is an accounting method that spreads the cost of a business asset over its useful life. Instead of recording the full purchase price as an expense in 1 year, you allocate a portion of the cost to each year the asset is in use.

For example, if you buy a work computer for £1,000 and expect it to last 5 years, depreciation lets you record £200 of that cost each year. This gives you a clearer view of your actual business expenses over time.

Accounting software can automate these calculations for you. If you're unsure which method suits your business, your accountant can help you decide.

What can be depreciated?

Only certain business purchases qualify for depreciation. To be depreciable, an asset must provide value to your business over more than 1 year and lose value over time through wear, use or obsolescence.

Assets you can depreciate include:

• Equipment and machinery
• Computers and software
• Vehicles and tools
• Office furniture
• Buildings and improvements

Assets you normally expense rather than depreciate include:

• Office supplies and stationery
• Inventory and stock
• Land, which doesn't typically lose value
• Items used up within 1 year

Intangible assets such as patents, trademarks and software licences also lose value over time. The process of spreading their cost is called amortisation, which works similarly to depreciation but applies to non-physical assets.

Why depreciation matters for your small business

Depreciation helps your small business in 3 key ways. It lets you track the true cost of running your business, reduce your tax bill through legitimate deductions, and maintain accurate asset values for loans or business sales.

Track true business costs

Your equipment, vehicles and technology lose value each year through normal wear and tear. Depreciation captures this loss of value as an expense on your profit and loss statement, giving you a more honest view of what it costs to run your business.

When you use depreciation, you capture the full cost of your assets and get more accurate profits. That helps you make better business decisions based on reliable financial data.

With many UK small business owners currently delaying equipment upgrades due to rising costs, according to Xero Small Business Insights data from 440,000 businesses, tracking the depreciation of your existing assets is more important than ever. Accurate depreciation figures help you understand the true replacement cost of ageing equipment and plan ahead.

Reduce your tax bill

Most business assets can be depreciated against your taxable income over several years. While depreciation itself is an accounting concept, HM Revenue and Customs (HMRC) uses capital allowances to determine how much tax relief you can claim on business assets.

HMRC sets specific rates for different asset types, with the main pool writing down allowance (WDA) at 14% and the special rate pool at 6%. Your accountant can make sure you're claiming the maximum allowable amount while staying compliant.

Understand your business value

The value of your assets affects the overall value of your business, and this is shown on your balance sheet. As assets depreciate, their book value decreases.

Keeping asset values updated is particularly useful if you're looking for a loan, as lenders often use assets as security. Accurate depreciation records also matter if you're planning to sell your business, since buyers will want to see realistic asset valuations.

How to calculate depreciation

Different depreciation methods suit different types of assets and business needs. The method you choose affects how quickly you recognise the cost of an asset in your accounts.

Straight-line depreciation

Straight-line depreciation spreads an asset's cost evenly across its useful life. It's the simplest and most commonly used method for small businesses.

The formula is:

Annual depreciation = (Asset cost - Salvage value) / Useful life in years

For example, a £5,000 computer with no salvage value and a 5-year useful life would depreciate by £1,000 each year. This method works well for assets that lose value at a steady rate, such as office furniture or fixtures.

Reducing balance depreciation

Reducing balance depreciation applies a fixed percentage to the asset's remaining book value each year. This front-loads the expense, meaning you claim more depreciation in the early years when the asset is newest.

The formula is:

Annual depreciation = Book value at start of year x Depreciation rate

For example, a £5,000 asset depreciated at 25% per year would lose £1,250 in year 1, then £937.50 in year 2 (25% of the remaining £3,750), and smaller amounts each year after. This method suits assets like vehicles and technology that lose value quickly in their first few years.

Units of production depreciation

Units of production depreciation links an asset's cost directly to how much you use it. Instead of spreading the cost over time, you spread it over the asset's expected total output or usage.

The formula is:

Depreciation per unit = (Asset cost - Salvage value) / Total expected units of production

For example, a delivery van costing £20,000 with an expected lifespan of 100,000 miles would depreciate by 20p per mile driven. In a year where you drive 15,000 miles, the depreciation expense would be £3,000. This method works well for manufacturing equipment or vehicles where usage varies significantly from year to year.

Double-declining balance depreciation

Double-declining balance depreciation is an accelerated method that applies twice the straight-line rate to the asset's remaining book value each year. It results in higher depreciation charges in the early years and lower charges later on.

The formula is:

Annual depreciation = Book value at start of year x (2 / Useful life in years)

For example, a £10,000 asset with a 5-year useful life would have a rate of 40% (2 divided by 5). In year 1, the depreciation charge would be £4,000, followed by £2,400 in year 2 (40% of £6,000). This method suits assets that lose a large portion of their value quickly, such as specialist technology or equipment that becomes outdated fast.

Understanding salvage value and useful life

Before you can calculate depreciation for any asset, you need to estimate 2 things: its salvage value and its useful life. Getting these estimates right directly affects the accuracy of your depreciation calculations.

Salvage value

Salvage value, also called residual value, is the amount you expect the asset to be worth at the end of its useful life. This is the price you could sell it for or its scrap value once you've finished using it.

For example, a company van might have a salvage value of £2,000 after 5 years because you could sell it second-hand. A laptop might have a salvage value of zero if it's unlikely to be worth anything after several years of use. You subtract the salvage value from the original cost before calculating depreciation.

Useful life

Useful life is how long you expect to use an asset in your business before it needs replacing. This isn't always the same as how long the asset could physically last; it's based on how long it will be practical and cost-effective for your business.

A computer might physically work for 10 years, but if you plan to replace it after 3 years because it will be too slow for your needs, its useful life for depreciation purposes is 3 years. HMRC provides guidelines on expected useful lives for common asset types, and your accountant can help you set realistic estimates.

Choosing a depreciation schedule

Your depreciation schedule sets out which method and rate you'll use for each type of asset. Getting this right from the start saves you time and keeps your accounts consistent.

According to accounting standards, both the useful life and residual value of an asset are considered accounting estimates that should be reviewed and updated as needed. A computer might only last 3 years, whereas a kiln in a factory could last 30.

HMRC defines assets with an expected business life of 25 years or more as long-life assets. You'll probably find that HMRC has a depreciation schedule for the types of assets in your business. Many small business owners simply follow those recommendations to keep things straightforward.

Where depreciation appears in your accounts

Depreciation shows up in 2 main places in your financial reports. Knowing where to look helps you get a clear picture of your business's financial health.

• On the profit and loss statement: you record depreciation as an operating expense. This reduces your total profit for the period and gives you a more accurate view of your business performance.
• On the balance sheet: each year, the depreciation charge for an asset is added to its accumulated depreciation. This running total is subtracted from the asset's original cost to show its current book value, also known as its net book value.

Accumulated depreciation is the total amount of depreciation you've recorded for an asset since you bought it. It increases each year and shows you how much of the asset's value has been used up so far.

Capital allowances and depreciation tax relief in the UK

In the UK, you can't deduct depreciation directly from your taxable profits. Instead, HMRC uses a separate system called capital allowances to give you tax relief on business assets. Understanding the difference between the 2 is important for getting your tax returns right.

Depreciation is an accounting concept that spreads an asset's cost in your financial reports. Capital allowances are the tax deductions HMRC lets you claim when you buy business assets. Your accountant will adjust for the difference between them when preparing your tax return.

Annual Investment Allowance (AIA)

The Annual Investment Allowance (AIA) lets you deduct the full cost of qualifying plant and machinery up to £1 million in the year you buy it. Most small businesses can claim the AIA on items like computers, office equipment, vehicles and machinery. This is often the most straightforward way to get tax relief on business assets.

Writing down allowances (WDA)

If your spending exceeds the AIA limit, or if an asset doesn't qualify for the AIA, you can claim writing down allowances instead. WDA lets you deduct a percentage of the asset's value each year.

HMRC groups assets into pools with different WDA rates:

• Main pool: 14% per year (for most plant and machinery)
• Special rate pool: 6% per year (for items with a long life, integral building features, and cars with high CO2 emissions)

Full expensing

Since April 2023, companies can claim 100% first-year relief on qualifying new plant and machinery through full expensing. This means you can deduct the entire cost of eligible assets from your profits in the year you buy them, with no upper limit. Full expensing applies to main pool assets, while a 50% first-year allowance applies to special rate pool assets.

Setting up depreciation for your small business

Setting up depreciation is straightforward once you break it into clear steps. Here's how to get started.

1. List all your business assets

Go through your business and identify every item that qualifies for depreciation. Record the purchase date, original cost and condition of each asset. This becomes the foundation of your fixed asset register.

2. Estimate useful life and salvage value

For each asset, estimate how long you'll use it and what it might be worth at the end. Use HMRC guidelines and your own business experience to set realistic figures. Your accountant can help with assets that are harder to estimate.

3. Choose a depreciation method for each asset

Select the method that best reflects how each asset loses value. Straight-line works for most office equipment, while reducing balance suits vehicles and technology. Apply the same method consistently for each asset type.

4. Set up your fixed asset register

Record all your assets, their depreciation methods and rates in a fixed asset register. Accounting software like Xero can automate this process and calculate depreciation charges for you each period.

5. Review and update annually

Check your depreciation schedule at least once a year when preparing your end-of-year accounts. Update useful life estimates if circumstances change, add new purchases and remove any assets you've sold or disposed of.

Simplify your depreciation with Xero

Tracking depreciation manually takes time and leaves room for errors. With cloud accounting software like Xero, you can set up a fixed asset register, automate your depreciation calculations, and keep your financial reports up to date without the manual effort.

Xero handles the maths and updates your profit and loss statement and balance sheet automatically, so you have accurate figures ready for tax time. That gives you the confidence that your books reflect the true value of your business assets. Get one month free.

FAQs on depreciation

Here are answers to some frequently asked questions about depreciation.

What is depreciation in simple words?

Depreciation is a way of spreading the cost of something your business owns, like a computer or van, across the years you use it. Instead of recording the full price as an expense when you buy it, you record a smaller amount each year.

What is the difference between depreciation and amortisation?

Depreciation applies to physical assets like equipment, vehicles and buildings. Amortisation is the same concept applied to intangible assets, such as patents, trademarks and software licences.

What is salvage value?

Salvage value is the amount you expect an asset to be worth when you're finished using it. You subtract this figure from the original cost before calculating how much to depreciate each year.

Can small businesses claim capital allowances?

Yes, most small businesses can claim capital allowances on qualifying business assets. The Annual Investment Allowance (AIA) lets you deduct up to £1 million of qualifying plant and machinery costs in the year you buy them.

What happens when an asset is fully depreciated?

When an asset is fully depreciated, its book value is zero or its salvage value. You can keep using it in your business, but you can no longer claim a depreciation expense for it. If you sell it, any money you receive is typically recorded as a gain.

How often should I review my depreciation schedule?

Review your depreciation schedule at least once a year, usually when preparing your end-of-year accounts. This helps you catch any changes in how long assets will last and keeps you compliant with current tax rules.