Chapter 2: Initial recognition

An item of property, plant, and equipment is recognized as an asset if:

1. future economic benefits associated with the item will probably flow to the entity; and
2. the cost of the item can be measured reliably.

Sufficient certainty that future economic benefits will flow to the entity is normally achieved only when the risks and rewards of the asset have passed to the entity. Normally, the transfer of risks and rewards is assumed to occur when an unconditional and irrevocable contract is in place.

In practice, the transfer of risks and rewards often occurs when the asset is delivered. Contractual commitments for acquiring property, plant, and equipment are disclosed, but the asset is not recognized until the transfer of risks and rewards has occurred.

Property, plant, and equipment might be acquired that, by themselves, might not generate economic benefits, but are necessary to enable other assets to do so. This might include assets necessary to ensure safety or to comply with environmental regulations.

These should be recognized as assets because they enable other assets to generate economic benefits. The carrying amount of those assets should be reviewed for impairment to ensure that the combined carrying amount does not exceed their combined recoverable amount.

Judgment is required when determining the unit of account (how individual items are identified and the extent to which items are aggregated). These judgments might include whether individual items are aggregated or large items should be recognized as separate components. It might be appropriate to aggregate individually insignificant items of property, plant, and equipment, such as molds, tools, and dies, and to apply the recognition criteria to the aggregate value.

Disaggregation or componentization is the separation of an asset into its significant components. Each component of an item of property, plant, and equipment that has a cost that is significant about the total cost of the item is depreciated separately if the component is consumed in a different manner or over a different period to the rest of the asset.

An aircraft and its engines, for example, would often be assessed as separate components and depreciated separately.

Replacement roof as a component An entity might acquire an asset at a price that reflects future expenditure that is necessary to bring the asset to the location and condition necessary for it to be capable of operating in the manner that management intends. A building might be acquired that requires substantial renovation such as a new roof. The subsequent cost of replacing the roof is capitalized, because the cost meets the asset recognition criteria in the standard. It increases the future economic benefits expected to be obtained from the building and can be reliably measured. Components of an asset are not separate classes of assets and are not separately disclosed in the financial statements.

Componentization of assets The determination as to whether the cost of an item is significant in the context of IAS 16 (see above) requires a careful assessment of the facts and circumstances. This assessment would include, at a minimum: comparison of the cost allocated to the item to the total cost of the aggregated property, plant and equipment; and consideration of the potential impact of componentization on the depreciation expense.

Aggregation of individually insignificant items IAS 16 does not prescribe what constitutes a separate item of property, plant and equipment, and allows a degree of judgement according to the entity’s circumstances. It does, however, suggest that, for individually insignificant items (such as molds, tools and dies), it may be appropriate to aggregate the items and to apply the recognition criteria to the aggregate value. However, IAS 16 requires that each part of an item of property, plant and equipment with a cost that is significant in relation to the cost of the item should be depreciated separately. Componentization is therefore implicitly required under IAS 16 for all significant components of property, plant and equipment.

Component depreciation of an asset that requires periodic replacement A small manufacturing company has recently acquired a new factory building for a cost of C1m with a residual value of C100000. This factory has a flat roof, which needs replacing every ten years at a cost of C100000. The cost of the roof is significant in relation to the total cost of the factory. The company is considering two alternative approaches: To regard the item as one asset and, therefore, to depreciate the whole factory over its useful economic life of 30 years, charging C30000 per annum. To regard the roof as a significant part of the item and depreciate the cost of the roof of C100000 over 10 years, giving a depreciation charge of C10000 per annum, and to depreciate the remainder of the factory of C900,000 down to its residual value of C100,000 over 30 years, giving a depreciation charge of C26,667. The second approach is correct. Significant components of a PPE item should be depreciated separately. The second approach appropriately reflects the consumption of economic benefits of the factory, with an even charge to the income statement of C36667 per annum, over the 30 years of the useful economic life of the factory.

Spare parts and servicing equipment are normally treated as inventory and expensed as consumed.

However, major spare parts and stand-by equipment are treated as property, plant, and equipment where they meet the definition of property, plant, and equipment.

Classification of stand-by equipment – example An entity has installed two turbines. One will produce energy for the plant, and the other will be used as a back-up in case the first turbine fails, or is otherwise rendered out of service. The probability that the spare turbine will ever be used is very low. The spare turbine is necessary, however, to ensure the continuity of the production process if the first turbine fails. The useful life of the stand-by turbine will equal the life of the plant, which is the same as the useful life of the primary turbine. IAS 16 states that stand-by equipment qualifies as property, plant and equipment when it meets the definition of property, plant and equipment. Although the definition in IAS 16 requires that the entity should expect to use the turbine during more than one period, it does not state that such use should be regular. Therefore, the spare turbine is classified as property, plant and equipment and should be depreciated from the date it becomes available for use (i.e., when it is in the location and condition necessary for it to be capable of operating in the manner intended by management).

Items acquired for safety or environmental reasons The acquisition of property, plant and equipment for safety or environmental reasons, while not directly increasing the future economic benefits of any particular existing item of property, plant and equipment, may be necessary in order for the entity to obtain the future economic benefits from its other assets. Such acquisitions qualify for recognition as assets, in that they enable future economic benefits to be derived from related assets in excess of what could otherwise have been derived. The resulting carrying amount of such an asset and the related assets is reviewed for impairment in accordance with IAS 36. IAS 16 cites the following example. Items acquired for safety or environmental reasons A chemical manufacturer is required to install certain new chemical-handling processes in order to comply with environmental requirements in relation to the production and storage of dangerous chemicals. Related plant enhancements are recognized as an asset because, without them, the entity is unable to manufacture and sell chemicals.