Replacement parts, residual value and depreciation in the context of property, plant and equipment – IAS 16

This article answers the following questions:

• What are property, plant and equipment?
• How do residual value and the separation of asset components affect depreciation?
• What depreciation methods can be applied?

Every business entity owns at least one component of property, plant and equipment – a mobile phone, a car or real estate. Each of these assets, despite differences in size or price, may qualify as property, plant and equipment that entities should properly recognise in their accounting books, particularly when subject to a mandatory statutory audit. Which regulations should finance departments of companies operating in Poland follow to fulfil this obligation correctly?

Property, plant and equipment required a separate standard that would precisely regulate the manner of their recognition in financial statements – ensuring that readers of the document can easily understand the entity’s investments in property, plant and equipment. This standard is International Accounting Standard 16 (IAS 16). Under this standard, property, plant and equipment (PPE) comprise tangible items:

• held by an entity for use over more than one reporting period,
• owned for production, service provision or administrative purposes.

IAS 16 also covers bearer plants – a category of non‑current assets used in agricultural activity. Previously, these atypical assets were included in IAS 41 (Biological Assets). An example of a bearer plant subject to IAS 16 is a fruit tree growing in an orchard, cultivated with the expectation that it will supply agricultural produce over a longer period (with a low likelihood of selling the tree itself as agricultural produce).

A fixed asset often requires the entity to incur significant expenditures to make it suitable for production or administrative use. At the moment it is entered into the accounting records, the asset is measured at acquisition cost or production cost.

How should expenditures on property, plant and equipment be recognised? 

We now understand how IAS 16 defines property, plant and equipment – but how can we determine whether a cost should be capitalised as part of a fixed asset? Consider the following example:

In a certain manufacturing company, a machine is serviced annually at a cost of PLN 25,000. During this year's service, the company decided to replace a component of the machine to enhance the efficiency of the production line. Thanks to the new component, the machine produces more units per hour.

The costs relating to the ongoing maintenance of fixed assets – in this case the PLN 25,000 servicing cost – must, in accordance with the standards, be recognised in profit or loss when incurred.

However, the initial value of a fixed asset may be increased by capitalising the cost of improvements. Under IAS 16, an improvement is recognised when both of the following conditions are met: 

• the expenditure can be reliably measured,
• the future economic benefits (e.g. extended useful life) exceed the current benefits without the expenditure. 

In such circumstances, capitalising the cost of the replacement part – thereby increasing the initial carrying amount of the fixed asset – is appropriate.

It is worth emphasising that fixed assets are often composed of components (a good example is an engine installed in a machine) that require replacement at specific intervals. The cost of such a component should also be recognised as part of the asset’s carrying amount and depreciated separately using its own depreciation rate – provided the conditions laid down in IAS 16 are met.

The life cycle of a fixed asset under IAS 16

Depreciation is an important issue, both in tax and accounting terms. IAS 16 sets out two key principles. 

• First, depreciation must be applied systematically throughout the asset’s useful life.
• Second, depreciation methods must be reviewed at least at the end of each financial year.

Returning to the earlier example – how should the finance department depreciate the machine if it has a useful life of 25 years, but its engine (a significant component) will wear out earlier and will be replaced halfway through the 25‑year period?

Under IAS 16, such machine components may be depreciated separately. In this case, the machine could be depreciated at 4% per year and the engine at 8%.

Depreciation charges are recognised either in profit or loss or included in the carrying amount of another asset (for instance, inventories produced using PPE). Importantly, the standard also refers to IAS 2, which governs the measurement and presentation of inventories.

From what amount should depreciation be calculated? 

Depreciation is calculated based on the initial carrying amount of the asset minus its residual value.

Residual value is the amount that the entity expects to obtain upon disposal of the asset at the end of its useful life; this is often the estimated net selling price. 

How does residual value affect annual depreciation?

Consider two scenarios:

If we analysed all PPE held by all entities, we would likely find that, in practice, residual values are often negligible and thus immaterial to depreciation calculations. Nevertheless, such situations do occur and require proper analysis by an experienced specialist or a statutory auditor.

What depreciation methods does IAS 16 provide?

When fulfilling the IAS 16 requirement to review residual value and useful life annually, one must also consider all internal and external information indicating the need to adjust these values.

If expectations regarding the use of the asset change – and thus expectations of future economic benefits – the depreciation method may also need to change. IAS 16 provides three methods:

• straight‑line method,
• declining balance method,
• units‑of‑production method (the natural method).

At a certain point in an asset’s life, it may become necessary to change the straight‑line method to the units‑of‑production or declining balance method.

A strong understanding of standards is key to accurate financial reporting

Accounting rules, particularly those relating to financial reporting, are complex. Although ongoing efforts aim to harmonise national accounting rules with international standards, certain differences persist. Therefore, it is essential to stay up to date with both Polish and global practices – especially IAS 16 on fixed assets and IFRS 16 regarding leases. Since virtually every organisation owns or uses tangible assets, ensuring correct accounting treatment is crucial. In case of any uncertainty, it is wise to seek support from financial audit experts.