What is depreciation?

Definition of depreciation

Depreciation is an accounting mechanism that's used to spread the value of a capital asset over the years that it'll be useful to the business.

Depreciation reduces the value of the asset on the business's balance sheet, because if you sold the asset later on, you wouldn't be able to sell it for as much as you bought it for.

It also appears as a day-to-day running cost on the business's profit and loss account, because the business has used up part of the asset's value in making its sales and earning its profit.

How to calculate depreciation

Depreciation can be worked out in two different ways in the UK.

The simpler method is called 'straight-line depreciation', whereby the amount of depreciation posted as a cost each year is the asset's original cost divided by the number of years it's going to be useful to the business.

For example, if you buy a computer that cost £900, and it's going to be useful to your business for 3 years, the depreciation would be £300 per year.

The other method is called 'reducing-balance depreciation', and it works like this.

Say you buy a car for £2,000 and you're going to depreciate it at 25% reducing balance. In the first year you own the car, the depreciation would be £2,000 x 25% = £500.

In the second year you own the car, you start the depreciation calculation not with the original cost, but with the cost less depreciation so far - so the depreciation would be (£2,000 - £500) x 25% = £375. And so it continues.