What is depreciation?

Why not just put the whole cost through when you buy it?

Because the asset will earn its keep over several years, and charging it all to the year of purchase makes that year look terrible and every later year look better than it was. Depreciation matches the cost to the years that benefit from it.

The mechanics are simple. Decide how long the asset will last and what it will be worth at the end, and charge the difference evenly over that period. Straight-line, as this is called, is the method most small businesses use. Reducing-balance charges a fixed percentage of the remaining value each year, so more early on.

Depreciation is a non-cash cost. No money leaves the business when it is charged; the money left when the asset was bought. That is why it is added back when working out cash flow, and why EBITDA exists.

A worked example

A joiner buys a £6,000 van and expects to run it for five years, with nothing worth counting at the end. Straight-line depreciation is £6,000 divided by five: £1,200 a year, or £100 a month.

Each month the books charge £100 to depreciation in the profit and loss and reduce the van's value on the balance sheet by the same amount. After two years the van shows at £6,000 cost less £2,400 accumulated depreciation, a net book value of £3,600.

If he sells it after two years for £4,000, the £400 above book value is a profit on disposal. If he gets £3,000, the £600 shortfall is a loss. Either way the van comes off the balance sheet.

How is depreciation different from capital allowances?

Depreciation is an accounting decision; capital allowances are the tax rules. HMRC does not accept your depreciation figure, because you chose it. Instead the depreciation is added back in the tax computation and replaced with capital allowances, which are worked out under fixed rules and often let you deduct most or all of the cost in the year of purchase.

So the van costs the same, but the accounts and the tax return spread that cost differently. This is normal, not an error, and it is why accounting profit and taxable profit rarely match.