Must I decline to review a former colleague's work?
Assuming you reviewing the paper would not violate any guidelines of the journal or conference in question, the primary issue is objectivity: can you review the paper on its own merits, or will your association with the author in question "color" your opinions?

Personally, I would never review a paper written by a former co-author or personal friend. However, I may accept the review of someone whom I know professionally but have not worked with in any formal capacity, provided that I am not working on a similar project.

In this particular example, you claim that the person is "a friend." If that is the case, then I would recommend leaning against accepting the review.

The issue of informing the journal editor is a separate matter. You may explain that the reason is you know the author, but you are not necessarily obligated to do so. If you want, you could simply say "I don't have the time right now," and that would be just as valid a reason as "it's a conflict of interest." But I don't think there's anything lost by informing the editor of why you don't feel comfortable providing the review.