How does depreciation impact the net book value of an asset?

Depreciation is a systematic allocation of the cost of a tangible asset over its useful life. As depreciation is recorded, it reduces the carrying amount or net book value of the asset on the balance sheet. This reflects the wear and tear or obsolescence that the asset experiences over time.

For example, if a piece of equipment is purchased for $100,000 and has a useful life of 10 years, each year, a portion of that cost will be recognized as an expense through depreciation. Assuming straight-line depreciation, the asset would lose $10,000 in value each year, resulting in a net book value of $90,000 at the end of the first year, $80,000 at the end of the second year, and so forth.

By continuously recognizing depreciation, the financial statements provide a clearer picture of the asset's actual value to the business over time, allowing stakeholders to assess the company’s financial position more accurately. This is crucial for making informed decisions regarding asset management, investment, and overall financial planning.