IAS 16 Property, Plant and Equipment

IAS 16 covers accounting treatment for property, plant and equipment (‘PP&E’), in particular: recognition of assets, depreciation charges, impairment losses, disclosure. PP&E are tangible items that (IAS 16.6):

(a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and

(b) are expected to be used during more than one period.

IAS 16 applies to all items of PP&E not covered by other IFRS. Paragraph IAS 16.3 specifies scope exemptions.

In some cases, the distinction between PP&E and inventory is not clear cut. The significance of such a distinction is that inventory, when utilised, is normally recognised as an expense impacting EBITDA, a performance measure that is key for many entities. On the other hand, PP&E is depreciated and depreciation expense is excluded from EBITDA, as the acronym implies.

Paragraph IAS 16.8 explains that items such as spare parts, stand-by equipment and servicing equipment are recognised as PP&E when they meet the definition of PP&E. Otherwise, such items are classified as inventory. Specifically, an item of PP&E must be expected to be used for more than one period (i.e. one year, though it is not stated explicitly).

There are cases where a minimum level of inventory must be maintained due to technical reasons. These instances can be split into two main categories:

1/ Such inventory cannot be sold or otherwise consumed, it stays within the PP&E until the end of the useful life and after that its value is significantly lower due to pollution etc.

2/ Such inventory is in circulation and is exchanged with new inventory.

Inventory described in 1/ can be (and in my opinion should be) treated as a part of PP&E as it usually does not meet the definition of inventory. Inventory described in 2/ should not be treated as a part of PP&E because it meets the criteria set out in IAS 2.

See the discussion on treating intangible assets (e.g. computer software) as a part of PP&E.

An item of PP&E is recognised as asset when (IAS 16.7):

(a) it is probable that future economic benefits associated with the item will flow to the entity and

(b) the cost of the item can be measured reliably.

Under IFRS, ‘probable’ is used in the meaning of probability exceeding 50%. IAS 16 clarifies that the flow of economic benefits may be indirect or be effected by a reduction of outflows (IAS 16.11).

IAS 16 does not prescribe the unit of account, therefore entities can aggregate individually insignificant items into one item of PP&E.

PP&E should be recognised at cost, which comprises (IAS 16.16):

(a) purchase price, including import duties and non-refundable purchase taxes, after deducting trade discounts and rebates.

(b) any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management.

(c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located

Paragraph IAS 16.17 provides examples of directly attributable costs that can be included in the cost of PP&E. Note that directly attributable costs do not need to be (are usually are not) incremental.

Any costs that are not directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management are expensed in P/L as incurred. Examples of such costs are given in IAS 16.19. Other examples include abnormal amounts of wasted material, labour, or other resources incurred in self-constructing an asset (IAS 16.22).

Common examples of costs that relate to acquisition or construction of PP&E, but are not included in its cost, include:

  • some costs incurred before the asset is acquired or constructed (see separate section below)
  • advertising and promotion
  • initial operating losses
  • trainings
  • setting up a temporary location for the time of development of existing location
  • salaries and wages of employees that remain idle due to relocation or development of existing PP&E
  • termination benefits paid to employees as a result of acquisition of PP&E that replaced their work

Significant judgement is needed when deciding how to account for costs that are incurred before the asset is acquired or before the beginning of construction. Costs relating to a research phase when the entity does not know specifically which asset will be acquired or when/how it will be developed should be expensed in P/L as incurred as they do not increase future economic benefits of the specific asset that will eventually  be acquired/developed.

Some payments for PP&E are not fixed and depend on future events. The most common example concerns payments that depend on future performance of the asset.

The first question that should be answered is whether this variable/contingent part of consideration should be recognised as a liability or not. Some analogy can be derived from IFRS 3 which requires recognition of a liability for contingent consideration at fair value with subsequent changes resulting from events after the acquisition date (e.g. meeting post-acquisition performance targets) recognised in P/L. IFRS 16 deals with similar issue and states that variable lease payments that depend on future activity of a lessee or an underlying asset are not included in the measurement of lease liability and right-of-use asset, they are recognised in P/L in the period in which the event or condition that triggers those payments occurs (see more discussion on variable lease payments).

So these are two rather opposing approaches to this matter, i.e. recognise a liability at fair value at acquisition with the corresponding impact on the asset vs. does not recognise the liability at all. There is also a third approach possible where any remeasurements of contingent consideration could have a corresponding impact on the carrying amount of PP&E, similarly to changes in decommissioning provisions.

This matter is on the IASB’s agenda and until it is resolved the accounting should follow the commercial substance of the transaction and, to some degree, be an accounting policy choice.

Directly attributable costs can be recognised as PP&E up to the point when an item of PP&E is in the location and condition necessary for it to be capable of operating in the manner intended by management. Any costs incurred after that are expensed as incurred. Examples of such costs include (IAS 16.20):

  • repairs and maintenance,
  • relocating the asset,
  • reorganising operations in which the asset is used,
  • costs incurred while an item capable of operating in the manner intended by management has yet to be brought into use or is operated at less than full capacity,
  • initial operating losses, such as those incurred while demand for the item’s output builds up.

IAS 16 does not contain any specific principles for subsequent expenditure on PP&E and, consequently, the general criteria apply. Therefore, for any subsequent expenditure to be recognised as an asset, there must be additional probable future economic benefit associated with it (i.e. the subsequent expenditure) that will flow to the entity.

The decision on how to account for subsequent expenditure will often boil down to a question of whether an existing part of PP&E is replaced or a new element/function is created. IAS 16 is more specific with replacement parts, which are included in the cost of PP&E, but the parts being replaced must be derecognised (IAS 16.13). It will often be the case that an entity will not know what is the cost of the replaced part as it was never separated when PP&E was recognised (IAS 16 requires a separation of  significant parts for depreciation purposes). In such a case, entity must estimate it, e.g. based on the current cost, and derecognise the old part after taking into account accumulated depreciation.

Repairs and maintenance are recognised in P/L as incurred (see more discussion in IAS 16.BC5-BC12).

Accounting for acquisition of a group of assets that do not do not constitute a business is covered in IFRS 3.

Many entities adopted a practical expedient to consider expenditures under certain amount as one-off expenses even when they would meet all the criteria for recognition as assets. Such an approach is not allowed by IFRS, but it can be adopted on materiality grounds.

The treatment of income generated during development of PP&E depends on whether this income was generated as a result of processes necessary to bring the asset to location and condition necessary for it to be capable of operating in the manner intended by management. If so, such income is deducted from the cost of PP&E. An example given in paragraph IAS 16.17(e) refers to income from selling samples produced when testing equipment. Another common examples includes contractual penalties received from contractors constructing an asset, which should also be deducted from its cost.

When income is generated as a result of operations that are not necessary to bring the asset to location and condition necessary for it to be capable of operating in the manner intended by management, they are recognised in P/L and not deducted from the cost of PP&E. As an example, paragraph IAS 16.21 refers to income earned through using a building site as a car park until construction of PP&E starts.

IASB plans to amend IAS 16 so that all income generated during development of PP&E will be recognised in P/L. In June 2017 IASB published the Exposure Draft Property, Plant and Equipment—Proceeds before Intended Use.

The estimate of the costs of dismantling and removing the item and restoring the site on which it is located is recognised as a provision and added to the cost of PP&E. This applies only when the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. When the obligation arises when producing inventories, such costs are added to the costs of inventory.

More discussion on accounting for decommissioning provisions, including changes in their amount, can be found in IAS 37.

When regular inspections are necessary for continuing use of PP&E, their cost can be added to the cost of PP&E. Similarly to replacement parts, any remaining carrying amount of the cost of the previous inspection is derecognised. If necessary, the amount relating to previous inspection that is included in the carrying amount of PP&E should be estimated (IAS 16.14).

The costs of future inspections/ overhauls cannot be anticipated and recorded as liability even if they are required by law as they are not a present obligation.

Repairs and maintenance costs are expensed in P/L as incurred (IAS 16.12). It may not be obvious whether an expenditure is a repair only or it enhances the asset.

When payment is deferred beyond normal credit terms, the cost of PP&E is the cash price equivalent at the recognition date (IAS 16.23). Unwinding of discount is recognised as expense, unless criteria for capitalisation of borrowing costs set out in IAS 23 are met. IAS 16 does not define normal credit terms so it is a judgement of the reporting entity and it depends on country and industry that the entity operates in.

Additionally, IAS 23 covers capitalisation (i.e. adding to the cost of an asset) of borrowing costs that are directly attributable to the acquisition or development of PP&E.

When an item of PP&E is acquired in exchange for a non-monetary asset (or a combination of monetary and non-monetary assets), the cost of such an item of PP&E is measured at fair value (IAS 16.24). The difference between the carrying amount of asset(s) given up and the fair value of asset acquired is recognised in P/L as a gain on disposal of the asset given up.

The fair value of the asset acquired is determined with reference to the fair value of asset given up, unless only the fair value of the asset received can be measured reliably or it is more clearly evident (IAS 16.26). If the fair value of neither the asset received nor the asset given up is reliably measurable, the asset received is recognised at cost that is the same as the carrying amount of the asset given up (IAS 16.24). Fair value measurements are covered in IFRS 13.

When the exchange transaction lacks commercial substance, the cost of PP&E acquired is measured at the carrying amount of the asset given up and no gain/loss is recognised in P/L (IAS 26.24). Paragraph IAS 16.25 clarifies when an exchange transaction has commercial substance. In general, a commercial substance test compares cash flows of the assets that were exchanged or the entity’s operations that were affected by the exchange. IAS 16 explains that The result of these analyses may be clear without an entity having to perform detailed calculations.

The cost of PP&E may be reduced due do government grants, which are covered in IAS 20.

IAS 16 allows a policy choice when measuring PP&E – cost model or revaluation model. The same measurement model should be applied to an entire class of PP&E (IAS 16.29).

Under cost model,  PP&E is carried at cost less any accumulated depreciation and any accumulated impairment losses (IAS 16.30). Depreciation and impairment are discussed later on in this chapter.

Cost model is by far more popular than the revaluation model discussed below.

Under the revaluation model, PP&E is carried at its fair value (i.e. revalued amount) less any accumulated depreciation and any accumulated impairment losses. Revaluations should be made with sufficient regularity to ensure that the carrying amount does not differ materially from fair value at the end of the reporting period (IAS 16.31,34). IAS 16 does require independent valuers to be involved in the process, but such an information should be disclosed (IAS 16.77(b)). When an entity switches from cost model to revaluation model, there is no need to apply this change in accounting policy retrospectively (IAS 8.17).

If an item of PP&E is revalued, the entire class of property, plant and equipment to which that asset belongs should be revalued to avoid a mixture of fair values determined at different dates (IAS 16.36,38). A class of PP&E is a grouping of assets of a similar nature and use in an entity’s operations. Paragraph IAS 16.37 gives examples of classes of PP&E.

The effect of increase in carrying amount of PP&E as a result of revaluation is included in other comprehensive income (OCI), but the decrease and impairment losses impact P/L. However, increase will be included in P/L to extent of previous decreases and impairment losses and similarly, decreases are included in OCI to the extent of previous accumulated increases. The resulting balance of revaluation surplus is accumulated as a separate part of equity under the heading of revaluation surplus (IAS 16.39-40).

The revaluation surplus can be transferred to retained earnings (without P/L impact) along with depreciation charge that is higher due to revaluation or when the related PP&E is derecognised (IAS 16.41). These transfers are not required but should be done, otherwise the balance of revaluation surplus with carried infinitely even if related assets will be long gone.

At the date of revaluation, the carrying amount must equal the fair value. This can be effected in two ways (IAS 16.35):

a/ by adjusting the gross book value of the asset and accumulated depreciation

b/ by eliminating accumulated depreciation and adjusting the gross book value of the asset to equal revalued amount

Example: entries at revaluation

Entity A has an asset which cost $10 million, has a useful life of 10 years and has been in use for 4 years. Therefore, accumulated depreciation is $4 million (straight line method, no residual value) and net book value is $6 million. This asset is carried at revalued amount and the fair value is estimated at $8 million.

The balances relating to the asset before revaluation are as follows:

DRCR
PP&E gross book value$10m
PP&E accumulated depreciation$4m

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Entity makes the following entries at revaluation date:

Approach #1

DRCR
PP&E gross book value$2m
PP&E accumulated depreciation$4m
Revaluation reserve (OCI)$2m

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Under this approach, the accumulated depreciation is eliminated and the gross book value equals the fair value. The resulting revaluation gain of $2m is recognised in OCI.

Approach #2

DRCR
PP&E gross book value$3.3
PP&E accumulated depreciation$1.3
Revaluation reserve (OCI)$2m

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Under this approach, the gross book value is adjusted upwards proportionately to the relative increase in carrying amount due to revaluation, i.e. by 33%.

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. It is usually recognised as an expense in P/L, unless it is included in the carrying amount of another asset. This happens when the future economic benefits embodied in an asset are absorbed in producing other assets, such as inventory (IAS 16.48-49).

Depreciable amount is the cost of an asset less its residual value. Depreciation is recognised even if the fair value of the asset exceeds its carrying amount, as long as the asset’s residual value does not exceed its carrying amount (IAS 16.52,54).

The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life (IAS 16.6). Consequently, an increase in the expected residual value of an asset because of past events will affect the depreciable amount, but expectations of future changes in residual value other than the effects of expected wear and tear will not (IAS 16.BC29).

In most cases,  the residual value is insignificant and the asset is depreciated until its carrying amount reaches zero (IAS 16.53).

Depreciation starts when the asset is in the location and condition necessary for it to be capable of operating in the manner intended by management. This is the same moment up to which directly attributable costs can be recognised as PP&E. An asset is depreciated over its useful life, which is the period over which an asset is expected to be available for use by an entity (IAS 16.6).

Useful life should be entity-specific and can be much shorter that the useful life that would be determined by others. It depends on the activity profile of an entity and its asset management policy (IAS 16.57). Useful life can be also expressed in the number of production or similar units expected to be obtained from the asset. Paragraph IAS 16.56 lists factors that should be considered in determining the useful life of an asset.

See also accounting for assets acquired in a business combination that the acquirer does not intend to use.

The depreciation method should allocate the depreciable amount of an asset on a systematic basis over its useful life and reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity (IAS 16.60). The most popular depreciation methods are straight-line method, diminishing balance method and units of production method, but entity may apply its own that best reflects the consumption of economic benefits of an asset.

Straight-line method is by far the most popular method of depreciation. As it name implies, depreciation charge is spread evenly over the useful life of an asset. It is suitable for majority of assets.

Under the diminishing balance method (often referred to as reducing balance method), the depreciation charge decreases over time as it is calculated based on carrying value at the beginning of the period instead of the original cost. This method is used with respect to assets subject to increased technical or commercial obsolescence.

There are a few approaches to the mechanics of this method. In general, the essence of this method is that a depreciation rate is applied to net book value (carrying amount) of the asset instead of its cost (as is the case under the straight line method). When there is a residual value of the fixed asset, entities can apply the same depreciation rate during the useful life. This depreciation rate can be calculated using the goalseek function in excel (an excel file can be found in the example below). When there is no residual value, it is much harder to get to zero at the end of useful life using the same depreciation rate applied to net book value for the whole depreciation period. In such cases, the diminishing balance method switches to straight line method when the depreciation rate under straight line method applied to cost is higher than would be under diminishing balance applied to net book value. The following examples illustrate these two approaches to diminishing balance method.

Example: diminishing balance depreciation with residual value

Entity purchased, for $12 million, an item of high-tech PP&E subject to increased technical obsolescence. The entity assesses that the asset will be used for 5 years, with most of its performance utilised in the first years. The residual value is $2 million. The depreciation is calculated as presented below. Note that depreciation rate is calculated using the goal seek function. You can download an excel file for this example.

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depreciation rate30%
original cost12
YearNet book valueDepreciation charge
112.003.61
28.392.53
35.861.76
44.091.23
52.860.86
Residual value2.00


Example: diminishing balance depreciation without residual value

Entity purchased for $12 million an item of high-tech PP&E subject to increased technical obsolescence. The entity assesses that the asset will be used for 5 years, with most of its performance utilised in the first years. The residual value is zero. You can download an excel file for this example.

Rate for diminishing balance depreciation: 30%
Rate for straight line depreciation: 20%
Cost of PP&E: 12
Depreciation charge under straight line depreciation: 2.4
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YearNet book valueDepreciation charge 
112.003.60@ diminishing balance rate
28.402.52@ diminishing balance rate
35.882.40@ straight line rate
43.482.40@ straight line rate
51.081.08@ straight line rate (until NBV = 0)
Residual value0.00

Sum of the digits depreciation is similar in effect to diminishing balance method. Its application is illustrated in the following example.

Example: sum of the digits depreciation

Entity purchased for $12 million an item of high-tech PP&E subject to increased technical obsolescence. The entity assesses that the asset will be used for 5 years, with most of its performance utilised in the first years. The residual value is zero.

Entity recognises depreciation expense using sum of the digits method as follows:

Year 1:  (5/15) x $12m = $4m
Year 2:  (4/15) x $12m = $3.2m
Year 3:  (3/15) x $12m = $2.4m
Year 4:  (2/15) x $12m = $1.6m
Year 5:  (1/15) x $12m = $0.8m
Total: (15/15) x $12m = $12m

You can download an excel file with these calculations.


In this method, the depreciation is based on the expected use or the output of an asset. Depreciation charge for a period reflects the share of total expected use/output consumed during that period.

A depreciation method that is based on revenue that is generated by an activity that includes the use of an asset is not allowed as revenue is affected by other inputs and processes, selling activities and changes in sales volumes and prices (IAS 16.62A).

Some entities depreciate assets based on what is the available depreciation tax allowance determined by the tax law for a particular asset. This approach can be adopted for financial reporting under IFRS only if such a depreciation also reflects the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. Extra care is needed when the tax law promotes expenditures on certain types of assets by allowing accelerated depreciation for tax purposes. In such cases, tax depreciation rates will hardly ever faithfully reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.

Each part of an item of PP&E with a cost that is significant in relation to the total cost of the item should be depreciated separately (IAS 16.43-47). Example given by IAS 16.44 uses airframe and engines of an aircraft that should be depreciated separately.

A particular aspect of separate depreciation concerns land and buildings. It is often not possible to legally separate buildings from land on which they are located. However they should be treated as separate assets and separately considered for depreciation purposes. Land has unlimited useful life (with limited exceptions) and should not be depreciated. Buildings should also be separated from land when determining residual values, therefore increase in value of land should not affect depreciation of buildings (IAS 16.58).

In some cases, the cost of land includes decommissioning costs. These costs are depreciated over the period of benefits obtained by incurring those costs, e.g. until the restoration is expected to take place (IAS 16.59).

As stated before, depreciation starts when the asset is in the location and condition necessary for it to be capable of operating in the manner intended by management. When an asset is not used during the period, it is still depreciated unless the units of production method is applied to that asset (IAS 16.55). Depreciation charge for that period reflects the consumption of the asset’s service potential that occurs while the asset is held (IAS 16.BC31). Such ‘idle’ periods occur usually just after the asset is acquired/developed and just before it is disposed of. Note that assets that fall under the scope of IFRS 5 are not depreciated.

See also impairment implications for unused assets.

The residual value, the useful life and the depreciation method should be reviewed at least at each financial year-end (IAS 16.51,61) with any changes accounted for prospectively under IAS 8 as changes in accounting estimates.

PP&E is subject to impairment requirements set out in IAS 36.

Paragraph IAS 16.66 clarifies that impairments or losses of items of PP&E, related claims for or payments of compensation from third parties and any subsequent purchase or construction of replacement assets are separate economic events and therefore their impact should not be offset in financial statements.

An item of PP&E is derecognised on disposal or when no future economic benefits are expected from its use or disposal (IAS 16.67). Gains or loss on derecognition is presented on a net basis in P/L and cannot be presented as revenue (IAS 16.68), unless PP&E is sold in the course of its ordinary activities (e.g. by car rental companies) (IAS 16.68A).

Disposal of PP&E is recognised at the date the recipient obtains control of that item of PP&E in accordance with the requirements for determining when a performance obligation is satisfied in IFRS 15 (IAS 16.69). IFRS 15 should also be applied when determining the amount of consideration (IAS 16.72).

Disclosure requirements are set out in paragraphs IAS 16.73-78. Additionally, paragraph IAS 16.79 encourages to disclose additional information that is not required.

When an entity adopted revaluation model, disclosures set out in IFRS 13 apply.

 


© 2018-2019 Marek Muc

Excerpts from IFRS Standards come from the Official Journal of the European Union (© European Union, https://eur-lex.europa.eu). The information provided on this website does not constitute professional advice and should not be used as a substitute for consultation with a certified accountant.