Depreciation basically signifies a steady decline in the value of asset.
Generally it is studied in terms of the period of time that such decline in the value took place. Therefore, it is also described as the value lost by the asset over useful life of the asset i.e.the period of time for which it had been put to use.
Even more simply depreciation is a decrease in asset’s worth because of its use in business activities. It is this depreciation (devaluation) that when you sell a used asset in the market it sells for lesser value as compared a similar asset in brand new condition. Mathematically it can be expressed as:
Depreciation = Cost of the asset paid when bought – Scrap value received at the end of useful life
Depreciation is treated as expense in the financial statements of the entity because any reduction in the value of asset is actually an expense as per the definition of IASB Framework. Even if we ignore the technical definitions, we can understand that any kind of loss reduces business’ profits and thus an expense.
Depreciation is calculated for non-current assets which are used for a period longer then one year and has significant value. Therefore, depreciation is also needed to be spread over the same length of time for which asset is expected to stay useful.
For example, If asset was bought for 100,000 and its useful life is expected to be 10 years after which it is supposed to have 5,000 scrap value therefore;
Depreciation = 100,000 – 5,000 = 95,000
Depreciation to be recognized in each period = 95,000 / 10 = 9,500.
So ever year an expense of 9,500 will be recognized in the Income Statement of the entity as depreciation of relevant asset.
One more thing to understand is that depreciation expense is a notional expense or simply non-cash expense which means an expense for which no cash outflow took place at the time when such expense was recognized. We don’t pay anybody in the name of depreciation expense just like salary expense that involves cash outflow. The reason is that depreciation is just an estimate of devaluation of asset. We have already paid for this asset in full when it was bought. But we are ‘expensing out’ only that worth of asset against which we have obtained economic benefits by using such asset.
In our example above, when asset is bought its cost i.e. 100,000 will be recorded in Statement of Financial Position (Balance sheet) as asset but each year 9,500 will be deducted and transferred to Income Statement as expense because asset is expected to have lost this much value after 1 year use. At the end of first year after depreciation is deducted, asset’s remaining balance will be 90,500 that signifies that asset still carry 90,500 worth of benefits in it (or 90,500 is the value that will be carried forward to next accounting year) and thus recorded in the accounting books at this value which is net of depreciation we have the terms carrying value or book value or net book value that are also used to mean remaining balance. In our example carrying value at the end of first year is 90,500.
Furthermore, we have to abide by different requirements of relevant accounting standards on how to calculate depreciation of non-current asset (also known as fixed asset) e.g. International Financial Reporting Standards (IFRSs) requires entity to use such depreciation methods that conform with the usage pattern of the asset. Due to such requirements and other factors, accountants have developed several different depreciation methods to give more accurate figure of depreciation expense in the financial statements. For example straight line method, reducing balance method, double declining balance method, sum of years digit method and many more.