Depreciation is the systematic allocation of the cost of a tangible fixed asset over its useful economic life. It is a non-cash expense on the P&L that reduces the book value of assets on the balance sheet. FP&A teams forecast depreciation as part of capital expenditure planning and EBITDA-to-cash-flow reconciliation.
In Depth
Depreciation represents the economic cost of using long-lived assets. When a company buys a piece of equipment for £100K with a 5-year useful life, the cost is not expensed immediately but spread over five years at £20K per year (using straight-line depreciation). This matching principle ensures costs are recognised in the periods that benefit from the asset.
The most common depreciation methods are straight-line (equal amounts each period), reducing balance (higher charges in early years), and units of production (based on actual usage). FRS 102 and IFRS require companies to select the method that best reflects the pattern of economic benefits.
For FP&A teams, depreciation forecasting is tied to the capital expenditure (CapEx) budget. Each new asset addition creates a depreciation stream that affects future P&Ls. The existing asset base generates ongoing depreciation from prior purchases. Together, these form the depreciation forecast.
It is important to understand that depreciation is a non-cash charge — it reduces reported profit but does not consume cash. The cash outflow occurred when the asset was purchased. This is why depreciation is added back in cash flow calculations and why EBITDA (which excludes depreciation) is used as a cash flow proxy.
For UK tax purposes, depreciation in the accounts is replaced by capital allowances, which have their own rules and rates. The Annual Investment Allowance (AIA) provides 100% first-year relief on qualifying expenditure up to £1M. Full expensing allows 100% first-year deduction for qualifying plant and machinery. These differences between accounting depreciation and tax capital allowances create deferred tax adjustments.
Real-World Example
A UK engineering company purchases CNC machinery for £500K with a 10-year useful life and no residual value. Annual straight-line depreciation is £50K. For tax purposes, the company claims full expensing in year one, creating a £450K timing difference that reduces the current tax bill by £112.5K (at 25%) but creates a deferred tax liability that unwinds over the remaining nine years.
Related Terms
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