Depreciation is the accounting representation of the value an asset loses over time. Physical assets — machines, vehicles, buildings, infrastructure — wear out, become obsolete, or simply age out of usefulness, and the financial picture has to track that. Depreciation is the mechanism: each year, some portion of the asset’s original cost is charged as an expense, and the asset’s recorded value drops accordingly.
Three drivers of depreciation:
- Use-related physical loss. Bearings wear, paint fades, tires bald. Wear-and-tear from running the asset hard.
- Time-related loss. Even unused, an asset deteriorates: rubber dries out, seals crack, finishes oxidise.
- Functional loss. The asset still works but is no longer adequate — a 10-year-old computer running modern software, a manufacturing line that can’t make today’s product specifications.
Two distinct values matter:
- Market value. What someone would pay for the asset today. Set by the secondary market, not by accounting.
- Book value. The asset’s recorded value on the company’s books, computed from its original cost and accumulated depreciation. An accounting construct that approximates market value but doesn’t track it precisely.
Two more end-of-life concepts:
- Salvage value. The actual or estimated sale value of the asset at the end of its planned useful life. Used in PW/AW calculations.
- Scrap value. The asset’s value at the end of its physical life (often much later than useful life), when it’s only worth selling for materials.
Why estimate asset value at all? Three reasons:
- To support business transactions — when a company is acquired or merged, or when assets are pledged as loan collateral.
- For replacement planning — knowing when an asset’s book value or market value approaches zero helps schedule its retirement and replacement.
- For taxes — depreciation expense reduces taxable income, lowering the tax bill. Tax depreciation rules (Canada’s CCA) are how this gets formalised.
Models
Two depreciation models are standard in Canada (and most of the engineering-economic literature):
Straight-line depreciation. The asset loses a constant dollar amount each year. Simple, but unrealistic for most assets — real assets lose value faster early in life.
Declining balance depreciation. The asset loses a constant percentage of its current book value each year. Faster value loss early, slower later. More realistic, and the basis of Canada’s CCA system.
Other models exist (units-of-production, sum-of-years-digits, MACRS in the US), but SL and DB are the two that show up in standard engineering-economics problems.
For tax-specific depreciation, see Capital cost allowance. For its use in replacement decisions, see Replacement decision and Equivalent annual cost.