What is depreciation? Definition, methods and tips for your small business

Published Friday 5 December 2025

Table of contents

• What is depreciation?
• What can be depreciated?
• Why depreciation matters for your small business
• How to calculate depreciation
• Choosing a depreciation schedule
• Where depreciation appears in your accounts
• Setting up depreciation for your small business
• Managing depreciation with accounting software
• FAQs on depreciation

Key takeaways

• Apply depreciation to spread the cost of long-term business assets like equipment, computers, and vehicles over their useful life rather than expensing them all at once, which provides a more accurate picture of your business profits and costs.

• Follow HMRC's recommended depreciation schedules and rates for different asset types to ensure tax compliance while maximizing your legitimate deductions, with main pool assets typically depreciating at 18% and special pool assets at 6%.

• Utilize accounting software to automate depreciation calculations and maintain accurate records, as it handles the complex mathematics and automatically updates your profit and loss statements and balance sheets.

• Review your depreciation schedule annually when preparing year-end accounts to ensure asset values remain accurate and you comply with any changes in tax regulations or accounting standards.

What is depreciation?

Depreciation means spreading the cost of a business asset over its useful life. When you buy a work computer for £1,000, depreciation spreads that cost across several years rather than recording it all at once.

Accounting software can automate these calculations for you. Work with an accountant if you're unsure about which method suits your business best.

What can be depreciated?

Depreciable are items that provide value to your business over multiple years. Only some business purchases qualify for depreciation.

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 (doesn't lose value)
• Items used up within one year

What are fixed assets?

are items that help generate income for more than one year.

Physical assets you can depreciate:

• Machinery and equipment
• Computers and technology
• Vehicles and tools
• Office furniture
• Buildings (but not land)

Intangible assets you can depreciate:

• Patents and trademarks
• Software licenses
• Copyrights

You can depreciate some leased assets if you control them long-term. Stock and inventory use different accounting rules and cannot be depreciated.

Why depreciation matters for your small business

Depreciation helps your small business in three key ways:

• track true costs – show the real expense of running your business
• reduce tax bills – lower your taxable income through legitimate deductions
• value your business – provide accurate asset values for loans or sales

Track true business costs

Track true business costs means accounting for all expenses, including asset wear and tear. Your equipment loses value each year and will eventually need replacing.

Depreciation shows exactly how much value your assets lost during the year. This expense appears on your profit and loss statement and reduces your reported profit.

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.

Reduce your tax bill

Reduce your tax bill by claiming depreciation as a business expense. Most business assets can be depreciated against your taxable income over several years.

HM Revenue & Customs (HMRC) sets specific depreciation rates for different asset types, with the two primary Writing Down Allowance rates being the main pool rate – 18% and the special pool rate of 6%. Your accountant can ensure 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. This is shown on your balance sheet. As assets depreciate, their book value decreases. Keeping this updated is important, especially if you're looking for a loan, as lenders often use assets as security.

How to calculate depreciation

Choose how quickly your assets lose value based on how you use them. Different depreciation methods suit different types of assets and business needs.

The three most common methods for small businesses are:

Straight line depreciation

Straight line depreciation spreads an asset's cost evenly across its useful life. A £5,000 computer lasting five years would depreciate £1,000 each year until it reaches zero value.

Reducing balance depreciation

Reducing balance depreciation front-loads the expense when assets lose value fastest. A £5,000 computer might depreciate £2,000 in year one, £1,200 in year two, and smaller amounts thereafter.

Units of production depreciation

Units of production depreciation links asset cost to actual usage. A delivery van costing £20,000 with an expected 100,000-mile lifespan would depreciate 20p per mile driven.

Choosing a depreciation schedule

To depreciate an asset, you must first estimate its lifespan. 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 three years, whereas a kiln in a factory could last 30. HM Revenue & Customs (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. It's common for small business owners to simply follow those recommendations.

Where depreciation appears in your accounts

Depreciation shows up in two main places in your financial reports. Knowing where to look helps you get a clear picture of your business's 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: The balance sheet lists your assets. Each year, the total depreciation for an asset is added to its 'accumulated depreciation'. This amount is subtracted from the asset's original cost to show its current book value.

Setting up depreciation for your small business

Setting up depreciation for your small business is straightforward. Most businesses follow HMRC's recommended depreciation schedules for different asset types.

Modern accounting software automates the calculations once you input your assets and chosen methods. The depreciation amounts flow automatically to your profit and loss statement and tax returns.

Work with your accountant to choose the right depreciation methods for your business. They can set up your system and ensure you're claiming all available tax benefits while staying compliant with regulations.

Managing depreciation with accounting software

Keeping track of depreciation manually takes time and effort. Using accounting software like the Xero accounting platform makes depreciation simpler. You can set up a fixed asset register to automatically calculate depreciation for all your assets.

The software handles the maths and updates your reports, so you have accurate figures ready for tax time. It saves you time and gives you the confidence that your books are up to date.

FAQs on depreciation

Here are answers to some common questions small business owners have about depreciation.

What is depreciation in simple words?

Depreciation is an accounting method used to spread the cost of a physical asset, like a computer or vehicle, over its useful life. Instead of recording the full cost as an expense in one go, you expense a portion of it each year.

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 continue to use the asset 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.

Can I change depreciation methods?

Generally, once you choose a depreciation method for an asset, you should stick with it for consistency. A switch, such as from a reducing balance to a straight-line basis, is treated as a change in accounting estimate and applied prospectively from the date of the change. Changing methods can be complex and may require you to file a specific form with HMRC. It's best to consult an accountant before making any changes.

How often should I review my depreciation schedule?

It's good practice to review your depreciation schedule at least once a year, usually when you're preparing your end-of-year accounts. This helps ensure your asset values are accurate and you're complying with any changes in tax rules.