What is Depreciation?

Quick Answer

Depreciation is the gradual decrease in the value of a business asset over time due to regular use, wear and tear, age, or technological changes.

Instead of treating the entire cost of a long-term asset as an expense on the day it is purchased, businesses spread that cost over the asset's useful life.

For example, if a café buys a coffee machine that will be used for several years, the cost is recognised gradually through depreciation instead of all at once.

What You'll Learn in This Guide

In this article, you'll learn:

What depreciation means in simple words
Why businesses record depreciation
Why depreciation is considered an expense
Which assets depreciate
A real-life example from Riya's Café

Note: In the previous lesson, we learned that depreciation is recorded using a Journal Voucher because it is an accounting adjustment and doesn't involve an immediate cash payment. Today, we'll understand what depreciation actually is and why every business records it.

The Story Continues...

A few days after completing the voucher lessons, Riya was reviewing her café's accounts with Sharma Ji. Everything seemed normal. Sales had been recorded. Purchases were updated. Payments and receipts matched perfectly.

Riya : So... are our accounts complete now?

Sharma Ji looked around the café. His eyes stopped at the large espresso machine near the counter.

Sharma Ji : How long have you been using that machine?"

Riya : Almost three years.

Sharma Ji : And does it work exactly like it did on the first day?

Riya : Not really. It's slower now. We've replaced a few parts. And it needs servicing more often.

Sharma Ji : That's completely normal. Every machine, vehicle, computer, and piece of equipment becomes older with time. Even if you take excellent care of it, its value doesn't stay the same forever.

Riya : So the value of the machine is decreasing every year?

Sharma Ji : Exactly. And that decrease in value is called depreciation.

Understanding Depreciation with a Simple Example

Imagine Riya bought a commercial coffee machine for ₹2,00,000. She doesn't buy it to use for just one day. She expects it to help the café serve customers for many years.

Every day, the machine:

Brews hundreds of cups of coffee.
Runs for several hours.
Experiences regular wear and tear.

As time passes, the machine becomes older. Its market value reduces, and one day it may need to be replaced. This gradual reduction in value is known as depreciation.

Why Does the Value of an Asset Decrease?

Riya : But why does the value go down?

Sharma Ji : There isn't just one reason. He pointed towards the coffee machine. Think about everything it goes through every day. Some common reasons are:

1. Regular Use

The more an asset is used, the more it wears out. A café's coffee machine used every day will lose value faster than one that's rarely used.

2. Wear and Tear

Moving parts become worn. Buttons stop working. Motors become less efficient. This natural deterioration reduces the asset's value.

3. Age

Even if an asset isn't used much, it still becomes older over time. Rubber parts may crack. Batteries lose efficiency. Materials naturally age.

4. New Technology

Sometimes an asset is still working perfectly. But newer, faster, and more efficient models enter the market. As a result, older machines become less valuable.

Sharma Ji : Your coffee machine might still make great coffee. But if a newer model can do the same work faster and use less electricity, buyers will usually pay less for the old one.

Does Every Asset Depreciate?

Riya : The coffee machine loses value. The furniture probably does too. What about the land the café is built on?

Sharma Ji : That's a great question and The answer is No. Some assets depreciate, while others generally do not.

Assets That Usually Depreciate

Coffee machines
Computers
Furniture
Vehicles
Office equipment
Machinery
Buildings (excluding land)

These assets lose value over time because they are used in the business.

Assets That Generally Do Not Depreciate

Land : Land usually does not depreciate because it doesn't wear out through normal business use. In many cases, its value may even increase over time.

We'll learn more about depreciating and non-depreciating assets in a later part.

A Common Beginner's Mistake

Riya : If my coffee machine is worth less today. Does that mean I lost money today?

Sharma Ji : Not at all. You paid for the machine when you bought it. No cash is leaving the business today. Depreciation simply recognises that the asset has been used to earn income during the year. It's an accounting adjustment, not a new payment.

Riya : So depreciation doesn't mean I'm paying for the machine again.

Sharma Ji : Exactly. It means you're recording the portion of the machine's cost that was used while running the business.

A Simple Way to Think About Depreciation

Sharma Ji picked up a notebook and wrote:

Buying an asset is like buying a box of candles.

Sharma Ji : If you light one candle every night, the whole box isn't used on the first day. You use a little bit each day. The same idea applies to many business assets. A machine, computer, or vehicle helps the business over several years. Instead of treating its entire cost as one year's expense, businesses recognise its cost gradually through depreciation.

Riya : So we're matching the cost with the years in which the asset is actually used.

Sharma Ji : Exactly. That's the idea behind depreciation.

Recap

By the end of the lesson, Riya understood that depreciation is the gradual reduction in the value of a business asset over time due to use, wear and tear, age, or technological changes. She also learned that depreciation is not another payment. Instead, it's an accounting method that spreads the cost of a long-term asset over the years it helps the business earn income. Most importantly, she realised that not every asset loses value in the same way—while machines, furniture, and vehicles usually depreciate, land generally does not. As they closed the café for the evening, Riya looked once more at the espresso machine.

Riya : It still works. But now I understand why its value doesn't stay the same forever.

Sharma Ji : And in the next part , we'll answer an even bigger question. If no cash is paid every year, why do accountants still record depreciation as an expense?

In the next part, you'll learn:

Why depreciation is recorded as an expense
How depreciation follows the Matching Principle in accounting
Why businesses don't expense the full cost of an asset in the year it's purchased
A practical example showing how depreciation affects a business's profit without affecting its cash balance

Why Is Depreciation Recorded as an Expense?

Riya : I understand that its value decreases over time, But one thing still confuses me.

Sharma Ji : I was expecting that question. You said depreciation is an expense. But we aren't paying any money every year. So why do accountants treat it as an expense? Let's solve this with a simple example.

Buying an Asset Isn't the Same as Using It

Sharma Ji drew two dates on a sheet of paper.

1 April 2026

Bought a coffee machine for ₹2,00,000

31 March 2027

The machine has been used for one full year.

Sharma Ji : Did the café use the machine only on the day it was purchased?

Riya : No. We've used it almost every day.

Sharma Ji : Exactly. The payment happened once. But the benefit of the machine continues for many years. So if the machine helps the café earn income every year, shouldn't part of its cost also be recognised every year?

Riya : That makes sense.

Why Not Record the Entire Cost as an Expense?

Riya : Why don't we simply treat the entire ₹2,00,000 as an expense when we buy the machine?

Sharma Ji : Because the machine will help the business for several years. If we record the whole amount as one year's expense, the profit for that year will look much lower than it actually is. The following years would show higher profits because the machine is still being used, but no expense would be recorded. That wouldn't give a true picture of the business.

A Simple Example

Suppose Riya's Café earned a profit before depreciation of ₹8,00,000 this year. The café also bought a coffee machine for ₹2,00,000, which is expected to be used for 10 years. If the entire ₹2,00,000 is treated as an expense immediately:

Year	Expense Recorded
Year 1	₹2,00,000
Year 2	₹0
Year 3	₹0

This doesn't reflect how the machine is actually used. Instead, if the cost is spread over 10 years, the depreciation expense would be: ₹20,000 per year. Now the expenses are matched with the years in which the machine helps earn income.

The Matching Principle

Riya : So we're dividing the cost over several years.

Sharma Ji : Exactly, In accounting, this idea is called the Matching Principle.

It means:

Expenses should be recognised in the same period as the income they help generate.

The coffee machine helps the café earn money every year. Therefore, part of its cost is recognised as an expense every year through depreciation. You don't need to memorise the term right now.

Just remember the idea: If an asset is used for many years, its cost should also be recognised over many years.

Does Depreciation Reduce Cash?

Riya : If we record ₹20,000 as depreciation this year. Does ₹20,000 leave the bank account?

Sharma Ji : No, The money left the business only once—when you bought the machine. Depreciation doesn't involve a new payment. It only updates the accounting records. This is why depreciation is often called a non-cash expense. It reduces the accounting profit, but it doesn't reduce the cash balance at the time depreciation is recorded.

Real-Life Example from the Café

Every morning, the coffee machine prepared hundreds of cups of coffee. Customers enjoyed fresh espresso, cappuccinos, and lattes. The machine played an important role in earning the café's income. By the end of the year, the machine had been used thousands of times.

Sharma Ji : Even though we didn't pay for it again, we did use part of its useful life. So depreciation records that year's usage.

Riya : It's like recognising that the machine has done one more year's work.

Sharma Ji : Exactly

Common Beginner Mistakes

Before ending the lesson, Sharma Ji pointed out a few misunderstandings.

Mistake 1: Depreciation Means Paying Again

No. The payment happens only when the asset is purchased. Depreciation is simply an accounting expense.

Mistake 2: Depreciation Means the Asset Stops Working

Not at all. An asset can continue working perfectly even after several years. Depreciation records the gradual reduction in its value, not whether it still works.

Mistake 3: Every Asset Is Expensed Immediately

Only assets that are used up within a short period are normally treated as immediate expenses. Long-term assets, such as machinery, furniture, or vehicles, provide benefits over multiple years, so their cost is recognised gradually through depreciation.

Recap

By the end of the lesson, Riya understood why depreciation is treated as an expense even though no cash is paid every year. She learned that businesses don't expense the full cost of a long-term asset immediately because the asset helps earn income over several years. Instead, accountants spread the cost across its useful life so that each year's financial statements present a fair picture of the business's performance. As they finished reviewing the accounts.

Sharma Ji : You now know what depreciation is and why businesses record it.

Riya looked at the coffee machine and said : I used to think depreciation was just an accounting rule. Now I see that it's a way of showing how an asset is gradually used in the business.

Sharma Ji : And next, we'll explore which assets are depreciated, what 'useful life' means, and the factors that affect depreciation before learning how to calculate it.

Which Assets Are Depreciated?

Sharma Ji : The coffee machine. The tables and chairs. The refrigerator. The delivery scooter. Do you think all of these will last forever?

Riya : Of course not. They'll all become old one day.

Sharma Ji : Exactly. That's why businesses record depreciation on many of these assets.

Assets That Usually Depreciate

Most long-term assets used in a business lose value over time because they are regularly used.

Some common examples include:

Machinery
Furniture
Computers and laptops
Office equipment
Delivery vehicles
Buildings (excluding the land)

These assets are expected to serve the business for several years, but their value gradually decreases.

Assets That Usually Do Not Depreciate

Riya : What about the land?

Sharma Ji : Land is different. Unlike machines or furniture, land does not wear out through normal business use. Because of this, land is generally not depreciated. Other assets that are generally not depreciated include:

Land
Investments (such as shares or mutual funds)
Inventory (because it is sold, not used over many years)

Remember: Depreciation applies mainly to long-term assets that are used in the business, not assets that are bought to be sold.

What Is Useful Life?

Riya : You keep saying it will be used for several years. How do accountants know how many years?

Sharma Ji : They estimate it. The useful life of an asset is the period during which the business expects to use that asset. It doesn't mean the asset will stop working after that time. It simply means the period over which the business expects to receive economic benefit from it.

Example

Asset	Expected Useful Life*
Laptop	3–5 years
Office Furniture	8–10 years
Coffee Machine	8–10 years
Delivery Scooter	5–8 years

*The actual useful life depends on the asset, its usage, company policy, and applicable accounting standards.

Riya : So useful life is an estimate, not a fixed guarantee.

Sharma Ji : Exactly.

What Is Residual (Scrap) Value?

Sharma Ji : When the café replaces the old coffee machine, do you think it will become completely worthless?

Riya : Maybe we could sell it as a second-hand machine.

Sharma Ji : That's right. Even after years of use, some assets can still be sold. The amount a business expects to receive at the end of an asset's useful life is called its residual value or scrap value.

Example

Suppose:

Cost of coffee machine = ₹2,00,000
Expected resale value after 10 years = ₹20,000

The machine isn't expected to become worthless. It is still expected to have some value at the end of its useful life. We'll use this concept when we learn depreciation calculations in the next chapter.

What Affects Depreciation?

Not every asset loses value at the same speed. Several factors influence how quickly an asset depreciates.

1. Frequency of Use

An asset used every day usually wears out faster than one used occasionally. For example, a café's coffee machine running all day may depreciate faster than one used only on weekends.

2. Maintenance

Regular servicing and proper care can help an asset remain in good condition for a longer time. Good maintenance doesn't stop depreciation, but it may help the asset stay useful for more years.

3. Technology

Sometimes an asset is still working well, but newer technology makes it less valuable. For example, an older computer may function properly, but businesses may replace it because newer models are faster and more efficient.

4. Nature of the Asset

Different assets have different expected lives. A building may be used for decades, while a laptop may need replacement much sooner.

Why Is This Important?

Riya : So why do accountants estimate useful life and residual value?

Sharma Ji : Because depreciation is based on these estimates. If the estimates are unrealistic, the depreciation expense may also be incorrect. That's why businesses review these estimates whenever necessary.

Bringing It All Together

Sharma Ji wrote one final summary on the whiteboard.

Term	Meaning
Depreciable Asset	A long-term asset whose value decreases over time
Useful Life	The estimated period the asset will be used by the business
Residual Value	The estimated value of the asset at the end of its useful life

Riya : These three ideas are connected.

Sharma Ji : Exactly, Before you can calculate depreciation, you need to know what asset you're depreciating, how long you'll use it, and what it may be worth in the end.

Recap

By the end of the lesson, Riya understood that depreciation applies mainly to long-term business assets such as machinery, furniture, computers, vehicles, and buildings. She also learned that land is generally not depreciated because it does not lose value through normal use. Most importantly, she discovered two new concepts:

Useful Life – the estimated period an asset will be used by the business.
Residual Value – the estimated amount the business expects to receive when the asset is sold or disposed of at the end of its useful life.

These concepts help accountants calculate depreciation accurately and prepare reliable financial statements. As they finished their discussion.

Sharma Ji : You now understand the ideas behind depreciation. The only thing left is learning how businesses actually record depreciation and how it affects the financial statements.

Riya : And after that. We'll finally learn how to calculate it.

Sharma Ji : Exactly. That's our next stop.

How Is Depreciation Recorded?

After learning what depreciation is, Riya had one final question.

Riya : We know an asset loses value over time. We know depreciation is an expense. But how do accountants actually record it?

Sharma Ji : That's the final piece of the puzzle.

Recording Depreciation in the Accounts

At the end of every financial year, businesses calculate the depreciation for each eligible asset. Since no cash is paid at that time, the transaction is recorded through a Journal Voucher.

The basic journal entry is:

Depreciation Expense A/c Dr.
      To Asset A/c

This entry has two effects:

It records depreciation as an expense.
It reduces the book value of the asset in the accounting records.

Where Does Depreciation Appear?

Riya opened the financial statements.

Riya : So where can I actually see depreciation?

Sharma Ji : Depreciation affects two important financial statements.

1. Profit & Loss Account

Depreciation is shown as an operating expense. Since expenses reduce profit, depreciation also reduces the business's profit for that accounting period.

For example:

Particulars	Amount
Revenue	₹10,00,000
Other Expenses	₹6,50,000
Depreciation	₹20,000
Net Profit	₹3,30,000

Riya : So depreciation reduces profit even though no money was paid today.

Sharma Ji : Exactly.

2. Balance Sheet

The Balance Sheet shows the asset after deducting depreciation.

Example

Suppose the café purchased a coffee machine for ₹2,00,000. If depreciation for the year is ₹20,000, the Balance Sheet will show:

Asset	Amount
Coffee Machine (Cost)	₹2,00,000
Less: Depreciation	₹20,000
Book Value	₹1,80,000

The machine still exists. The business still owns it. Only its book value has changed.

Book Value vs Market Value

Riya : If the Balance Sheet shows ₹1,80,000. Can I definitely sell the machine for ₹1,80,000?

Sharma Ji : Not necessarily. The book value is the value shown in the accounting records after depreciation. The market value is the price someone is actually willing to pay. These two values may be different.

For example:

A machine with a book value of ₹1,80,000 might sell for ₹1,70,000.
Or it might sell for ₹1,90,000 if demand is high.

Depreciation helps calculate the book value, not the market price.

Why Is Depreciation Important?

Riya : It seems like a lot of work. Why do businesses bother recording depreciation every year?

Sharma Ji : Because it helps present a more accurate picture of the business.

Depreciation helps businesses:

Show a realistic value of long-term assets.
Match the cost of an asset with the years it is used.
Calculate profit more fairly.
Prepare reliable financial statements.

Without depreciation, assets would continue to appear at their original purchase price, even after years of use. That wouldn't reflect the true financial position of the business.

Common Misconceptions

"Depreciation means the asset is broken. "

Not true. An asset can still work perfectly even after years of depreciation.

"Depreciation creates a cash payment every year."

No. The cash payment happens only when the asset is purchased. Depreciation is simply an accounting entry.

"Every asset is depreciated."

No. Only certain long-term assets are depreciated. Land, for example, is generally not depreciated.

"Depreciation is optional."

No. Businesses are expected to record depreciation appropriately so that their financial statements present a fair view of their financial position and performance.

Riya's Biggest Lesson

Riya : When we bought this machine, I thought accounting ended with recording the purchase.

Sharma Ji : Buying the asset is only the beginning. Good accounting also tracks how that asset is used over time.

Riya : So depreciation isn't about losing money. It's about showing the true value of the asset and the true profit of the business.

Sharma Ji : Exactly. That's why every accountant needs to understand depreciation.

Recap

By the end of this chapter, Riya understood that depreciation is much more than an accounting term. It is a systematic way of recognising the cost of a long-term asset over the years it helps the business earn income.

She learned that:

Depreciation is recorded using a Journal Voucher.
It appears as an expense in the Profit & Loss Account.
It reduces the book value of an asset in the Balance Sheet.
It helps present fair and accurate financial statements.

Most importantly, she realised that depreciation is not about making another payment—it is about recording how an asset is gradually used in the business.

Chapter Summary

In this lesson, you learned:

✅ What depreciation is
✅ Why businesses record depreciation
✅ Why depreciation is an expense
✅ Which assets are depreciated
✅ Useful life and residual value
✅ Journal entry for depreciation
✅ How depreciation affects the Profit & Loss Account
✅ How depreciation affects the Balance Sheet
✅ Common misconceptions about depreciation

Coming Up Next – Methods of Depreciation

The next morning, Riya opened the accounts and asked : "We know the coffee machine loses value every year. But how do we decide how much value it loses?"

Sharma Ji : That's where different methods of depreciation come in.

In the next lesson, we'll learn the two most common methods—Straight Line Method (SLM) and Written Down Value (WDV)—with simple calculations and practical examples from the café.

Key Takeaways

Depreciation is the gradual reduction in the value of a long-term asset over time.

It is caused by use, wear and tear, age, or technological advancements.

Depreciation is a non-cash expense because no new payment is made when it is recorded.

It follows the Matching Principle, which spreads an asset's cost over its useful life.

Land generally does not depreciate, while machinery, furniture, vehicles, and computers usually do.

Depreciation reduces profit and the book value of an asset but does not reduce cash.

Frequently Asked Questions (FAQs)

1. What is depreciation in accounting?

Depreciation is the gradual decrease in the value of a long-term business asset over time due to regular use, wear and tear, age, or technological advancements. Businesses record depreciation to spread an asset's cost over its useful life.

2. Why is depreciation recorded as an expense?

Depreciation is recorded as an expense because a long-term asset helps generate income over several years. Instead of charging the full cost in the year of purchase, businesses allocate a portion of the cost to each accounting period.

3. Is depreciation a cash expense?

No. Depreciation is a non-cash expense. The cash payment is made only when the asset is purchased. Recording depreciation does not involve any additional cash outflow.

4. Which assets are depreciated?

Long-term tangible assets used in a business are generally depreciated. Examples include:

Machinery
Furniture
Computers
Vehicles
Office equipment
Buildings (excluding land)

5. Does land depreciate?

Generally, no. Land does not depreciate because it does not wear out through normal business use. In many cases, its value may even increase over time.

6. What causes depreciation?

Assets depreciate due to several factors, including:

Regular use
Wear and tear
Age
Technological changes
Obsolescence

7. What is the useful life of an asset?

Useful life is the estimated period during which a business expects an asset to provide economic benefits. It is used to calculate depreciation.

8. What is residual value in depreciation?

Residual value (or scrap value) is the estimated amount a business expects to receive when an asset reaches the end of its useful life.

9. How is depreciation recorded in accounting?

Depreciation is usually recorded using a Journal Voucher with the following journal entry:

Depreciation Expense A/c Dr.
To Asset A/c

This records depreciation as an expense and reduces the asset's book value.

10. Where does depreciation appear in the financial statements?

Depreciation appears:

As an expense in the Profit & Loss Account.
As a reduction in the asset's book value in the Balance Sheet.

11. Does depreciation reduce profit?

Yes. Depreciation reduces the accounting profit because it is treated as an operating expense. However, it does not reduce the business's cash balance.

12. What is the difference between book value and market value?

Book value is the value of an asset shown in the accounting records after deducting depreciation. Market value is the price the asset could be sold for in the market. The two values are often different.

13. Can a fully depreciated asset still be used?

Yes. A fully depreciated asset can continue to be used if it is still in working condition. Full depreciation does not necessarily mean the asset has become unusable.

14. Is depreciation mandatory in accounting?

Yes. Businesses are generally expected to record depreciation on depreciable assets so that their financial statements present a fair and accurate view of their financial position and performance.

15. Why is depreciation important?

Depreciation helps businesses:

Show the true value of long-term assets.
Match expenses with the income they help generate.
Calculate profit accurately.
Prepare reliable financial statements.
Comply with accounting principles and standards.