Finance & Accounting

All you need to know about IAS 16

IAS 16 specifies the accounting treatment in relation to property, plant, and equipment (PPE), making it one of the essential and widely used standards. The key topics covered in IAS 16 are the recognition of property, plant, & equipment, measurement at the time of recognition and after recognition, impairment of property, plant, & equipment (although IAS 36 goes into greater detail on impairment), and derecognition.

Why is IAS 16 needed?

Property, Plant, and Equipment (i.e., PPE) is a well-known standard that tackles a number of issues. Consider all of the varied ways you could try to account for the acquisition of a machine if there were no guidelines laying out consistent approaches to be followed for the various issues of how much and when to account for machinery.

One company may attempt to expense the entire cost of a machine at the time of purchase. Another firm may strive to capitalize it as an asset while never allowing any of the cost to affect the firm’s profits. Perhaps it is convenient to simply capitalize the machinery as an asset and expense (or depreciate) it in accordance with the local income tax legislation that allows for tax depreciation. Thus, these are all the possible scenarios but the principles exist in Accounting Standards for their proper application. If every company does not follow the same underlying principles as to when to capitalize fixed assets and when to account for the expense relating to the machinery (buildings, or furniture & fixtures, etc.), then there would be significant differences in accounting treatments and it would not be possible for investors & providers of capital to compare the performance of a firm over time or compared to other firms.

The objective of IAS 16

The basic purpose of this Accounting Standard is to define the accounting treatment for property, plant, and equipment so that the readers and interested parties of financial statements may interpret information about an entity’s investment in property, plant, and equipment as well as changes in such investment. The primary concerns in accounting for PPE are the principles for the recognition of these assets, the assessment of their carrying amounts, and the depreciation charges and impairment losses that are to be reported in relation to them.

Property, plant, and equipment are tangible assets retained for use in the production or delivery of goods or services, for rental to others, or for administrative functions, and are intended to be used for quite a long time.

Recognition and measurement

The cost of a property, plant and equipment is ought to be recognized as an asset if and only if the expected economic benefits connected with the item are likely to accrue to the business and the cost of the item is capable of being measured accurately.

This recognition principle applies to all expenditures incurred at the time of acquisition or construction of a piece of property, plant, or equipment, as well as costs incurred later after recognition to add to, replace a part of, or service it.

An item of PPE that qualifies for asset recognition must be valued at its purchase price. The cash price equivalent of the asset at the recognition date is used to determine the cost of such property, plant, and equipment. If payment is delayed for more than the ordinary terms of credit, then the difference between the cash price equivalent and the entire payment is to be recognized as interest throughout the credit period unless the interest is recognized in the item’s carrying amount as required by IAS 23.

The cost of a property, plant and equipment will consist of the following:

• after deducting trade discounts and rebates, its purchase price, comprising import tariffs and non-refundable taxes related to purchase
• any expenses directly related to bringing the asset to the location and condition required for it to operate in the way as it is planned by management
• the initial estimate of the expenses of dismantling and removing the item, as well as restoring the site where it is placed, the responsibility that an entity assumes either when the item is bought or as a result of using the item for purposes other than producing inventory during that period.

Accounting treatment after recognition

A company’s accounting policy must be either the cost model or the revaluation model, and it must be applied to an entire category of property, plant, and equipment.

Cost model:

After being recognized as an asset, a plant or equipment is to be carried at its cost less any accrued depreciation and any cumulative impairment losses.

Revaluation model:

After being recognized as an asset, the property or equipment whose fair value could be reliably measured will be held at a revalued amount equal to its fair value that exists at the date of its revaluation excluding all the subsequent accumulated depreciation & accrued impairment losses. Such revaluation must be performed on a regular & appropriate basis to ensure that the carrying amount of the PPE does not deviate considerably from that which ought to be established using fair value at the end of the entity’s reporting period.

If the carrying amount of a PPE has increased as a result of a revaluation, the increase is to be recognized in other comprehensive income and should be accumulated in equity under the head of the revaluation surplus. But the increase must be recognized in profit or loss to the extent that it reverses a revaluation decline of the same asset earlier recognized in profit or loss. If the carrying amount of a PPE decreases as a result of a revaluation, the decline must be recognized in the profit or loss. Furthermore, the decline will have to be considered in other comprehensive income to the extent of any Cr. balance that is remaining in the revaluation surplus with regard to that individual asset.

Depreciation

According to IAS 16, the systematic distribution of an asset’s depreciable amount over its useful life is referred to as depreciation. The cost of an asset, or any quantity substituted for cost, less its residual value, is the depreciable amount. Each component of a piece of property, plant, or equipment whose cost is substantial/considerable in relation to the total cost of the item must be depreciated separately. Except when it is included in the carrying amount of another asset, the depreciation charge for each period must be recognized in profit or loss. The method of depreciation employed must represent the manner in which the entity is likely to utilize the asset’s future economic benefits.

IAS 16 also clarifies that the residual value of an asset (PPE) is the estimation of the amount that a business enterprise would receive today from disposing of the asset after deducting the predicted disposal costs if the item were already of the age and condition expected at the end of its useful life.

The depreciation method should be examined at least once a year, and if the pattern of benefit consumption changes, the depreciation method should be updated prospectively as a change in estimate under IAS 8. Future price decreases may be indicative of a higher rate of consumption of the future economic advantages represented in an item.

Further, to assess if an item of property, plant & equipment is impaired or not, a company must apply IAS 36 on Impairment of Assets^[1]. A property, plant, or piece of equipment may not be carried for more than its recoverable value. The higher amount of an asset’s fair value minus costs to sell and its value in use is the recoverable amount. When a claim for compensation from a third party for impairment becomes receivable, it is included in profit or loss.

De-recognition

In addition, when an item of property, plant, or equipment is disposed of or when no future economic advantages are foreseen from its use or disposal, the carrying amount is de-recognized.

The difference that exists between the proceeds and the carrying amount is referred to as the gain or loss on disposition, and it should be recorded in profit and loss. When an entity rents some assets and later stops renting them, the assets should be transferred to inventories at their carrying amounts as soon as they are held for sale in the ordinary course of business.

Conclusion

IAS 16 addresses all areas of accounting for property, plant, and equipment. It states that an item of property, plant, and equipment should be recognized (or capitalized) as an asset if the future economic benefits connected with the asset are likely to accrue to the enterprise and the cost of the asset is capable of being determined reliably.

Read our Article:Comprehensive Understanding of Ind AS (Indian Accounting Standards)