Accounting PPE Explained: Recognition, Measurement, Derecognition and a Worked Example

Property, plant and equipment is the class of tangible assets an entity holds for use in production or supply, for rental, or for administration, and expects to use for more than one period. Accounting PPE treatment is governed by IAS 16, and almost every examinable difficulty in it comes from one of three questions: what belongs in the carrying amount, over what pattern it is written down, and what happens when the asset's value or life turns out to be different from the estimate.

The standard is unusually procedural, which makes it a good candidate for learning the sequence rather than memorising the outcomes.

Accounting PPE explained: the recognition test

An item is recognised as an asset only when both conditions are met: it is probable that future economic benefits associated with it will flow to the entity, and its cost can be measured reliably.

The test is applied to a unit of account the entity chooses. Individually trivial items such as tools are frequently aggregated; major components of a single physical asset are frequently separated, because component accounting is not optional where the parts have materially different useful lives. An aircraft has an airframe and engines; a building has a structure and a roof. Depreciating the whole at one rate is the error the component requirement exists to prevent.

Spare parts and servicing equipment are the routine trap. They are inventory unless the entity expects to use them over more than one period, in which case they are PPE.

Initial measurement: what belongs in cost

Cost is the purchase price plus any directly attributable cost of bringing the asset to the location and condition necessary for it to operate as management intends, plus the initial estimate of dismantling and site restoration where an obligation exists.

Directly attributable costs include site preparation, delivery and handling, installation and assembly, professional fees, and the cost of testing, net of the proceeds from selling anything produced during testing. Since the 2020 amendment those sale proceeds go to profit or loss rather than being deducted from cost, a change that catches out anyone working from an older textbook.

Excluded are the costs of opening a new facility, introducing a new product, conducting business in a new location, administration and general overhead, and any cost incurred after the asset is capable of operating as intended even if it has not yet been brought into use. Operating losses in the run-up to full capacity are not capitalised, however tempting the presentation.

Depreciation, and the three judgements inside it

Depreciation allocates the depreciable amount over the useful life. Three estimates drive it, and all three are judgements and not facts.

Useful life is the period over which the asset is expected to be available for use by this entity, not its physical life. A vehicle replaced on a four-year policy has a four-year useful life whatever the manufacturer says.

Residual value is the amount the entity would obtain now from disposal, if the asset were already of the age and condition expected at the end of its useful life. Because it is a current-price estimate, it rarely rises with inflation, and a residual value set at acquisition and never revisited is a common audit finding.

Method must reflect the pattern in which the benefits are consumed: straight line, diminishing balance or units of production. A revenue-based method is prohibited, on the reasoning that revenue reflects factors other than consumption of the asset.

Depreciation begins when the asset is available for use and continues until derecognition, including periods of idleness. It does not stop because the asset is temporarily out of service, and it is charged even where the fair value exceeds the carrying amount. Land is not depreciated except where it has a limited life, such as a quarry.

The cost model against the revaluation model

After recognition the entity chooses a policy per class of assets and applies it to the whole class.

Under the cost model, carrying amount is cost less accumulated depreciation and accumulated impairment losses. Simple, and what the large majority of entities apply.

Under the revaluation model, carrying amount is fair value at the revaluation date less subsequent depreciation and impairment. Revaluations must be frequent enough that carrying amount does not differ materially from fair value, which for volatile classes means annually.

The asymmetry in where the gain or loss goes is the part most often examined. An increase goes to other comprehensive income and accumulates in a revaluation surplus, except to the extent it reverses a decrease previously recognised in profit or loss, in which case it goes to profit or loss first. A decrease goes to profit or loss, except to the extent of a credit balance in the surplus for that same asset, in which case it goes to other comprehensive income first. The rule is per asset, not per class, which is why a class-level revaluation still needs asset-level records.

Once revalued, depreciation is charged on the revalued amount, so the depreciation expense rises. The entity may transfer the excess depreciation from revaluation surplus to retained earnings each year, but this is a reserves movement and never touches profit or loss.

A worked example of accounting PPE

A manufacturer buys a press on 1 January for £480,000, with £22,000 of delivery and installation, £8,000 of testing, and £3,000 of staff training. Useful life eight years, residual value £40,000, straight line. On 31 December of year three the press is revalued to £420,000.

Initial cost. £480,000 + £22,000 + £22,000 is wrong: training is excluded, because it is not a cost of bringing the asset to working condition. Cost is £480,000 + £22,000 + £8,000 = £510,000. The £3,000 training is an expense.

Annual depreciation. (£510,000 − £40,000) ÷ 8 = £58,750.

Carrying amount after three years. £510,000 − (3 × £58,750) = £333,750.

On revaluation. Fair value £420,000 against carrying amount £333,750 gives an increase of £86,250. No previous decrease was taken to profit or loss, so the whole £86,250 goes to other comprehensive income and sits in the revaluation surplus.

Depreciation from year four. The remaining useful life is five years and residual value is unchanged, so (£420,000 − £40,000) ÷ 5 = £76,000. The charge has risen by £17,250, which is the amount that may be transferred each year from revaluation surplus to retained earnings.

Working the accounting PPE numbers through in this order — cost, depreciation, carrying amount, revaluation, revised depreciation — is what the marking scheme follows, and showing the excluded item explicitly earns the mark that listing only the included ones does not.

Impairment, and how it interacts with revaluation

IAS 16 hands impairment to IAS 36, and the interaction is where candidates lose marks even when both standards are known separately.

At each reporting date the entity looks for indicators that an asset may be impaired: a fall in market value beyond the expected passage of time, adverse changes in the technological, market, economic or legal environment, a rise in interest rates affecting the discount rate, evidence of physical damage or obsolescence, or internal evidence that economic performance is worse than expected. Where an indicator exists, the recoverable amount is calculated as the higher of fair value less costs of disposal and value in use.

An impairment loss on an asset carried under the cost model goes straight to profit or loss. On a revalued asset it is treated as a revaluation decrease, which means it goes to other comprehensive income to the extent of any credit balance in that asset's revaluation surplus, and only the excess reaches profit or loss. This is the same asymmetry as an ordinary revaluation decrease, and forgetting that it applies to impairments as well is the usual error.

After an impairment, depreciation is recalculated on the reduced carrying amount over the remaining useful life. The estimate of that life frequently needs revising at the same time, because whatever caused the impairment often shortens it.

Changes in estimate, which are never retrospective

Useful life, residual value and depreciation method are reviewed at least at each financial year end. A change to any of them is a change in accounting estimate under IAS 8, accounted for prospectively: the carrying amount at the date of change is spread over the revised remaining life. Prior periods are not restated, and no comparative figures move.

The distinction matters because it is the one point where a student's instinct usually runs the wrong way. Discovering that a machine will last ten years, not eight feels like a correction, and a correction of a prior-period error would be retrospective. It is not an error; the original estimate was reasonable on the information then available, and the standard treats the new information as belonging to the current and future periods alone.

Subsequent expenditure, and derecognition

Subsequent expenditure is capitalised only if it meets the same recognition test as the original. Day-to-day servicing is expensed. A major inspection or overhaul required for the asset to continue operating is capitalised as a replacement component, and the carrying amount of the previous inspection is derecognised even if it was never separately identified at acquisition.

Derecognition occurs on disposal or when no future benefit is expected. The gain or loss is the difference between net disposal proceeds and carrying amount, recognised in profit or loss and never presented as revenue. Any balance remaining in the revaluation surplus for that asset transfers directly to retained earnings — it does not recycle through profit or loss, which is the single most reliable examination trap in the whole standard.

The accounting treatment, end to end

Accounting PPE is one topic with four decisions in it, and the treatment of each follows from the one before. Recognition asks whether the item is an asset at all. Measurement asks what it is carried at, on the day it arrives and afterwards. Depreciation spreads that amount over the periods that benefit. Derecognition asks what happens when it leaves.

Property plant and equipment accounting is examined as that sequence and not as four separate rules, and an answer that takes them in order is doing the work the question set. The PPE accounting example above runs one asset through all four, because the interactions — a revaluation changing the depreciation charge, a disposal releasing a revaluation surplus — are where the marks sit.

A second point on treatment, explained here because it catches people out: the property plant and equipment accounting rules apply to the whole class once a policy is chosen, not to the individual asset. Revalue one building and every building in that class is revalued with it, which is why a PPE accounting example that revalues a single asset in isolation is describing something the standard does not permit.