IAS 16 – Property, Plant and Equipment
What is the core accounting challenge addressed by IAS 16?
Property, plant and equipment (PPE) represent a prime example of one of the most significant challenges in financial reporting: how to measure the results of an entity’s operations when a major portion of the costs incurred in the current period also affect future reporting periods. In other words, the central objective of the accounting treatment of PPE is to allocate its cost over the periods in which revenue, i.e., economic benefits arising from its use, is recognised in the financial statements.
Why is PPE recognised as an asset and measured initially at cost?
The solution to this issue is based on one of the cornerstones of accounting theory, as expressed in the Conceptual Framework for Financial Reporting: the recognition criteria for an asset. According to the Framework, an asset represents future economic benefits expected to flow to the reporting entity as a result of past transactions and events. Moreover, recognition of an asset in the statement of financial position requires that it can be measured reliably. The acquisition cost of PPE, from which the entity expects to derive economic benefits over more than one reporting period, is therefore recognised as an asset in the financial statements.
There is no dispute that the amount paid for PPE represents its fair value at the acquisition date, since it reflects an arm’s-length transaction between a willing buyer and a willing seller, and is therefore a reliable estimate. In accordance with the matching principle for expenses in the financial statements, PPE is depreciated over the periods during which the entity expects to benefit from its embedded economic benefits, and in the way the entity expects to consume those benefits.
How is the carrying amount of PPE assessed over time?
Like all assets, PPE must at each subsequent reporting date represent no less than the future economic benefits expected to flow to the entity. Consequently, if at some point its carrying amount no longer represents such future economic benefits, its value must be reduced accordingly.
What practical implementation questions arise in applying IAS 16?
In practice, applying these basic principles to PPE raises many implementation questions, such as: what is the precise date of recognition? Which costs should be included in the initial measurement of PPE? How should depreciation expense be determined? And how should the revaluation model be applied?
Which measurement models are permitted for PPE and why?
Traditionally, the measurement basis for PPE in the financial statements has been historical cost. However, IFRS Accounting Standards, in order to enhance the relevance of financial reporting — and in contrast to US GAAP — permit the use of the revaluation model. This model has existed in IFRS since its early stages alongside the cost model. It raises several accounting questions, such as: how should a revaluation surplus be treated? Is depreciation required? And most importantly, what exactly does the statement of financial position seek to portray when PPE is used in production?
It should be noted that current IFRS Accounting Standards provide for diverse measurement bases: from historical cost through the revaluation model to fair value measurement. Adoption of the relevant measurement basis is based on a functional distinction between three major categories of assets: inventory, PPE and investment property. This distinction is based on the intended use of the asset rather than its inherent nature. Thus, real estate can qualify as inventory, PPE, or investment property, depending on its intended use. Accordingly, the accounting challenge stems from the function of the item, rather than its nature: investment property is held to earn rentals, for capital appreciation, or both. Therefore, the most relevant measurement basis for investment property is fair value, with changes in fair value recognised in profit or loss as permitted by IAS 40 Investment Property. Conversely, since the intended use of inventory is its sale in the ordinary course of business, cost is the relevant measurement basis, consistent with the principles of revenue recognition.
How does the intended use of PPE determine its subsequent measurement?
The function of PPE is its use in the production or supply of goods or services, for rental to others, or for administrative purposes. The accounting treatment therefore focuses on allocating its cost over the periods during which revenue is recognised from its use. The desire to match depreciation expense with the benefits derived from PPE use leads to two possible measurement bases: cost and revaluation. Under the cost model, PPE is measured at cost less accumulated depreciation and accumulated impairment losses. Under the revaluation model, an item of PPE whose fair value can be measured reliably is carried at a revalued amount—its fair value at the date of revaluation less subsequent accumulated depreciation and accumulated impairment losses. Revaluations are not required to be performed every reporting period, and positive differences (i.e., increases in value) arising on revaluation are generally recognised in other comprehensive income and accumulated in a separate component of equity (revaluation surplus).
The rationale for the revaluation model is to enhance the relevance of information on the carrying amount of PPE and, at the same time, to recognise depreciation expenses that reflect current market prices. However, this model imposes a heavy reporting burden on entities, particularly given the increase in depreciation expenses recognised in subsequent periods when fair values rise.
What is the scope of IAS 16 and how does it interact with other standards?
IAS 16 is the primary standard addressing the accounting treatment of PPE. The Standard sets out the principles for recognition and initial measurement, subsequent measurement, derecognition of PPE, and disclosure requirements. It allows entities to choose an accounting policy for subsequent measurement: the cost model or the revaluation model, provided the same policy is applied to all assets within a class of PPE. However, it does not require the same policy to be applied across all classes of PPE.
Two other IFRS Accounting Standards are directly related to PPE:
- IAS 36, Impairment of Assets, which applies to the impairment of PPE and sets requirements for testing, recognising, and measuring impairment losses.
- IFRS 5, Non-current Assets Held for Sale and Discontinued Operations, which prescribes the accounting treatment when PPE is classified as held for sale.
In addition, when a reporting entity, in the ordinary course of business, sells items of PPE that were previously held for rental, those assets must be reclassified as inventory when they are no longer leased and are held for sale. From that point, they are accounted for under IAS 2, Inventories. A common example is found in leasing companies that purchase vehicles, lease them under operating leases, and later sell them.