Financial Accounting · Depreciation

Depreciation Concepts and IAS 16 Basics Explained

Updated 11 October 2026 · Fact-checked

Depreciation spreads the depreciable amount of a non-current asset (cost less residual value) over its useful life, so each period bears a fair share of the cost. This follows the accruals concept. IAS 16 requires it. Carrying amount is cost less accumulated depreciation.

Understand Depreciation Concepts and IAS 16 Basics

A business buys a machine for $100,000 that will help earn revenue for five years. If you charged the whole $100,000 to profit in year 1, year 1 would look terrible and years 2 to 5 would look too good. That is misleading.

The accruals concept (also called matching) says you recognise expenses in the period in which they help earn the related income, not when cash is paid. Depreciation applies this to non-current assets. It is an allocation of cost over the asset's life. It is not a way of valuing the asset at market price, and it does not set aside cash.

IAS 16 *Property, Plant and Equipment* gives the key terms:

Cost: the purchase price (after trade discounts), import duties and non-refundable taxes, plus costs directly needed to bring the asset to its location and working condition, such as delivery, installation and testing.
Useful life: the period over which the entity expects to use the asset, or the number of production units it expects to get from it. It is not always the physical life.
Residual value: the estimated amount the entity would get from disposing of the asset now, after deducting disposal costs, if it were already at the age and condition expected at the end of its useful life.
Depreciable amount: cost (or revalued amount) less residual value.
Carrying amount: cost less accumulated depreciation (and impairment losses).

Depreciation is charged to profit or loss as an expense, with the matching credit to accumulated depreciation, a contra account to the asset. Land normally has an unlimited life and is not depreciated. Buildings are depreciated separately from the land they stand on. Depreciation begins when the asset is available for use and continues even if the asset is idle.

Key formulas to remember

Cost of an asset: Cost = purchase price (net of trade discount) + import duties and non-refundable taxes + directly attributable costs; Include delivery, installation and testing. Exclude general overheads, training and administration costs.
Depreciable amount: Depreciable amount = Cost − Residual value; This is the total amount to charge to profit or loss over the useful life.
Carrying amount: Carrying amount = Cost − Accumulated depreciation; Also called net book value. It is not market value. Impairment losses are also deducted if there are any.
Straight-line annual charge: Annual depreciation = (Cost − Residual value) ÷ Useful life in years; Gives an equal charge each full year.
Depreciation journal: Dr Depreciation expense (profit or loss); Cr Accumulated depreciation (statement of financial position); Do not credit the asset cost account.

How to solve Depreciation Concepts and IAS 16 Basics questions

Use this method for any question on depreciation concepts or IAS 16 terms.

1Read what the question asks for: a definition, a statement about the concept, or a calculated figure such as depreciable amount or carrying amount.
2List the data: cost items, useful life, residual value, and the date of purchase.
3Build the cost correctly. Add directly attributable costs. Remove items that are not part of cost, such as training and general overheads.
4Deduct residual value from cost to get the depreciable amount.
5Divide by useful life if you need the annual charge, then multiply by years held to get accumulated depreciation.
6Calculate carrying amount as cost less accumulated depreciation.
7For concept statements, test each one: depreciation is allocation, not valuation; it is not a cash fund; land is not normally depreciated.
8Check that your answer is the figure asked for, and in the right units.

Quickest way: Cost, residual, life, then label

When to use it: Use this for number-entry and multiple-choice questions where time is short.

Underline the figure asked for: depreciable amount, annual charge or carrying amount.
Total the cost items and drop anything that is not directly attributable.
Subtract residual value only for depreciable amount or annual charge. Never subtract it for carrying amount unless depreciation has reduced the asset to that level.
For a concept question, remember: depreciation allocates cost, follows accruals, and does not create cash.
Eliminate options that mention market value or saving cash for replacement.

Common mistakes in Depreciation Concepts and IAS 16 Basics

Saying depreciation shows the asset's current market value.
The words carrying amount and value sound alike.
Fix: Remember that depreciation is cost allocation. Carrying amount can be far above or below market value.
Deducting residual value from cost when asked for carrying amount at purchase.
Students mix up depreciable amount with carrying amount.
Fix: At purchase, carrying amount equals cost. Residual value only affects the amount to be depreciated.
Leaving out installation or delivery costs from cost, or including training costs.
Students use the invoice price alone or add every cost they see.
Fix: Include costs needed to bring the asset to working condition. Exclude training, general overheads and costs after the asset is ready for use.
Believing depreciation provides cash to replace the asset.
The word charge is confused with setting money aside.
Fix: Depreciation is a non-cash expense. It reduces profit and asset carrying amount but no cash leaves the business.
Depreciating land.
Land and buildings are often bought together.
Fix: Separate the two. Land normally has an unlimited life, so depreciate only the buildings.
Crediting the asset cost account in the depreciation journal.
Students think the asset itself shrinks.
Fix: Credit accumulated depreciation. Cost stays on the ledger, and carrying amount is the net of the two.

Worked examples

Example 1

A company buys a machine. Invoice price $48,000 less 10% trade discount. Delivery $1,500, installation $2,500, staff training $1,000. Estimated residual value $5,000 and useful life 4 years. Calculate (a) the cost, (b) the depreciable amount, (c) the straight-line annual depreciation.

Show the solution

Price after trade discount: $48,000 × 90% = $43,200.
Add delivery $1,500 and installation $2,500: $43,200 + $1,500 + $2,500 = $47,200.
Training of $1,000 is not directly attributable to bringing the asset to working condition, so it is expensed.
Depreciable amount = $47,200 − $5,000 = $42,200.
Annual depreciation = $42,200 ÷ 4 = $10,550.

Answer: Cost $47,200; depreciable amount $42,200; annual depreciation $10,550.

Example 2

Using the machine in the previous example, what is the carrying amount at the end of year 2? Which of these statements about depreciation is correct? A) It sets aside cash to replace the asset. B) It allocates cost over the useful life. C) It measures the asset at market value. D) It applies to all land.

Show the solution

Accumulated depreciation after 2 years = $10,550 × 2 = $21,100.
Carrying amount = cost − accumulated depreciation = $47,200 − $21,100 = $26,100.
Option A is wrong: depreciation is non-cash and creates no fund.
Option C is wrong: carrying amount is not market value.
Option D is wrong: land normally has an unlimited life and is not depreciated.
Option B matches the accruals concept and IAS 16.

Answer: Carrying amount $26,100; the correct statement is B.

Exam tips

Learn the five IAS 16 terms as precise definitions. Objective tests often use them as answer options.
For depreciable amount, always subtract residual value. For carrying amount, always use accumulated depreciation.
Watch for distractors in cost: training, general overheads and trade discounts are common traps.
In concept questions, reject any option that says depreciation provides cash or measures market value.
Write the figure you calculated beside the question so you can check it against the exact term requested.

Practice questions from Depreciation

Depreciation Concepts and IAS 16 Basics in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Depreciation Concepts and IAS 16 Basics: frequently asked questions

What is depreciation in simple terms?

It is the systematic spreading of an asset's cost over the years it is used. It matches the cost with the income the asset helps earn. It is an expense, not a cash payment.

What is the difference between depreciable amount and carrying amount?

Depreciable amount is cost less residual value, and it is the total to be charged over the asset's life. Carrying amount is cost less accumulated depreciation at a given date. The first is fixed at the start, while the second falls each year.

Why does the accruals concept require depreciation?

The asset helps earn revenue over several periods. The accruals concept says expenses should be matched with the revenue they help produce. Spreading the cost through depreciation does this.

Is useful life the same as physical life?

No. Useful life is how long the entity expects to use the asset, which may be shorter than its physical life because of obsolescence or company policy. Estimates should be reviewed regularly.