Q11: What is depreciation?
Non-current assets are usually intended to be used by a firm for many years. Except usually for land, these non-current assets will not last forever. They can be expected to be used up, wear out and eventually become obsolete (a bit like each of us, I suppose). Nothing lasts forever. To reflect the reality that non-current assets are being used up in a business over time as part of the operations of a firm, depreciation of non-current assets is usually calculated in a firm’s accounts. It is an estimate of how much of a firm’s non-current assets (such as Property, plant & equipment) have been used up during a period as part of a firm’s business operations and processes. This is usually done by allocating on some basis the original cost of each non-current asset of a firm to each period (usually a year) that the non-current asset is expected to be useful to a firm.
Depreciation is not the decline in market value of non-current assets (such as Property, plant & equipment). This is a misconception many people can have. Rather, depreciation is the process of turning an asset into an expense.
And because depreciation involves estimates and judgements, it is an important area of costs for most firms to understand.