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Plain‑English explainer of HKAS 16 / IAS 16 for students, junior accountants and non‑specialists who find official standards too dense to read.
This article is based on Hong Kong Accounting Standards (HKAS / HKFRS), which are fully aligned with IAS / IFRS except for minor local tweaks, so the same principles generally apply under IAS / IFRS unless noted otherwise. The goal is to unpack HKAS 16 Property, Plant and Equipment (equivalent to IAS 16) using plain English and practical, real‑life examples instead of technical jargon. It is written for students, junior accountants, audit juniors and finance professionals who want to understand not just “what the standard says” but how to actually read and prepare financial statements in line with it.
When you see “the company” or “the entity” below, you can think of any entity that prepares general purpose financial statements under HKFRS / IFRS.
The starting scenario: how much of this project goes into PPE?
Imagine this situation: the company buys a piece of land in the New Territories to build a new factory. From buying the land, hiring contractors and engineers, doing site clearance and running tests, all the way until the plant is ready for commercial production, you see piles of invoices: construction work, testing materials, trial-production sales, even income from renting out part of the land as a temporary car park during construction.
Typical questions in practice include:
- Which items should be included in the cost of property, plant and equipment (PPE)?
- Which items should be expensed in profit or loss immediately?
- Can revenue from selling products during the testing phase be used to “offset” the cost of PPE?
- How should income and expenses from side activities (like the temporary car park) be treated?
This article follows one main thread: “How much cost actually goes into PPE?” The goal is to give you a systematic framework so that when you face a real-life project with many different costs and incidental income, you can classify each item with confidence.
What You Should Be Able To Do After Reading?
By the end, you should be able to:
- Explain the three main components of the initial cost of PPE, with common examples of capitalisable costs.
- Understand why decommissioning, removal and restoration obligations are capitalised, and how they link to other standards.
- Spot several types of expenditure that look “related” to the new facility but must not be capitalised, such as start-up costs, advertising and initial operating losses.
- Explain why revenue and related costs during the testing phase go through profit or loss, instead of reducing the cost of PPE.
- Apply all of the above in a combined scenario with multiple costs and incidental income, deciding line by line what should go into PPE and what should stay in profit or loss.
1. Define what “cost” of PPE really means
Before we talk about “capitalising the cost of an asset”, we need to be clear what “cost” actually includes. Under HKAS 16 Property, Plant and Equipment (equivalent to IAS 16), the initial cost of PPE can be grouped into three broad elements:
- Purchase price
- Directly attributable costs
- Estimated costs of dismantling, removing and restoring the site
Together, these three elements represent the total investment necessary to bring the asset to the location and condition required for it to operate as management intends.
Purchase price: more than just the sticker amount
The purchase price is not just the list price on the invoice. It usually includes:
- Less: trade discounts and rebates
- Plus: import duties and non‑refundable taxes
Example: the entity buys a machine with an invoice price of 1,000,000, gets a 50,000 discount, and pays 20,000 of non‑refundable import duty. The basic purchase price for capitalisation is 970,000. This is the most obvious piece of cost, but it is not the whole story.
Directly attributable costs: what it takes to get the asset ready
Directly attributable costs are the expenditures necessary to bring the asset to the location and condition required for it to be capable of operating as intended by management. Common examples include:
- Transport and handling costs to bring the asset to the site
- Installation and commissioning costs so the machine operates as expected
- Site preparation costs for a factory, such as demolishing old buildings and levelling the land
- Professional fees such as engineers, surveyors and architects
- Employee benefits for staff working directly on constructing or installing the asset (for example, the project engineering team’s salaries and related costs)
A frequent practical question is: which staff costs can be capitalised? As a rule of thumb, only costs of employees who are directly involved in constructing or installing the asset qualify as directly attributable; general management and administrative staff costs are expensed as period costs.
Dismantling, removal and restoration: the hidden future costs
We will look at this in more detail in the next section, but here is the key idea: if, when the entity acquires or uses an asset, it takes on a present obligation to dismantle, remove or restore the site in the future, the present value of that obligation is included in the cost of PPE. At the same time, a corresponding liability is recognised.
In short, the initial cost of PPE is not only “how much cash did we pay the supplier?”. It includes all necessary costs incurred to bring the asset to the condition where it is ready for use as intended by management.
2. Decommissioning and restoration obligations: why they are part of cost
In some industries, acquiring or building an asset comes with an unavoidable “clean-up” responsibility. For example:
- An oil company installing an offshore platform must dismantle the equipment and restore the seabed at the end of its life
- A mining company leasing land may be required to backfill and re‑green the site after extraction
- Some lease contracts require the tenant to restore the factory premises to its original condition at the end of the lease term
In all these situations, the entity takes on an obligation at the point it invests in the asset. HKAS 16’s logic is: because this obligation arises from acquiring or using the asset and will lead to future cash outflows, it should be treated as part of the asset’s cost.
Link to HKAS 37: provisions and the related liability
From a liability perspective, this restoration obligation is a present legal or constructive obligation to be settled in the future. It is therefore within the scope of HKAS 37 Provisions, Contingent Liabilities and Contingent Assets. In practice, the usual steps are:
- Estimate the present value of the future dismantling, removal and restoration costs
- Debit PPE to include this amount in the asset’s cost
- Credit a corresponding liability, often labelled “decommissioning, restoration and similar obligations” or something similar
Over time, the liability unwinds as discounting interest expense, which is recognised in profit or loss. Meanwhile, the capitalised part in PPE is depreciated over the asset’s useful life using the entity’s depreciation policy.
Why capitalise instead of expensing later?
Economically, the entity can only use the asset because it is willing to pay the dismantling and restoration costs in the future. If we ignore this element and capitalise only the construction or purchase costs, the asset is understated, depreciation is too low, and profit over the asset’s life is overstated. The financial statements would not reflect the true cost of using the asset.
Capitalising dismantling, removal and restoration costs makes the recognised carrying amount closer to the asset’s “full economic cost”, which improves the reliability of financial information.
3. Costs that must not be capitalised: common borderline items
In practice, many expenditures look related to a new factory or new production line but HKAS 16 clearly says they should not be capitalised and instead must be expensed when incurred. If handled incorrectly, these items can inflate asset balances and distort profit.
Key categories that must not be included in PPE cost include:
Costs of opening a new facility
Examples:
- Marketing activities before opening a new branch
- Recruiting and training new staff
- Opening ceremonies or launch events for a new plant
These costs are linked to starting operations, building organisational capacity or brand image, not to bringing a specific PPE item to the condition necessary for operating as intended. Therefore, they are not part of PPE cost.
Costs of introducing a new product or service
Examples:
- Market research for launching a new product
- Promotional activities for a new service line
- Initial customer engagement and trial service costs
These relate to business development rather than making a particular asset ready for use. The standard wants to avoid entities “stuffing” various operating costs into assets and then spreading them over long depreciation periods.
Advertising and promotional expenditure
Branding and image-building costs such as advertising campaigns, promotional events and marketing materials must not be included in PPE cost. Even if they occur around the time the new facility begins operation, their nature is still promotional, so they are expensed.
Initial operating losses after the asset is ready for use
Some entities incur losses in the early period of a new production line because utilisation is low or operations are not yet efficient. Even though these losses are connected to the new asset, they must not be added “back” to the cost of PPE. HKAS 16 focuses on the point when the asset is capable of operating as intended by management.
Once that point is reached, subsequent underperformance—such as low production volume, higher scrap rate or early-stage inefficiency—should be reflected in profit or loss, not by adjusting the cost of PPE.
4. Before-use revenue and costs: the testing phase
During construction and installation, entities often run tests to make sure equipment or systems perform as expected. In this testing stage, two types of figures may appear:
- Costs incurred for testing
- Revenue from selling products or providing services that arise incidentally during testing
A common question is: if products produced during testing are sold, can the revenue be used to reduce the cost of PPE? Historically, some practices allowed this, but the current HKAS 16 has narrowed this approach significantly.
Testing costs: capitalise, but draw the line carefully
Costs directly related to testing and necessary to bring the asset to the condition required for its intended use are usually treated as directly attributable costs. Examples include:
- Materials and labour consumed during testing
- Expenses for repeated trial runs to fine‑tune equipment settings
However, once the asset has reached the condition where it can operate as management intends, further “trial production” to explore different product mixes is no longer capitalisable. From that point onwards, such costs are expensed. The key question is whether the asset is still in the construction/testing phase or already capable of operating in its intended manner.
Revenue and costs from testing: through profit or loss, not netted against PPE
Under the current requirements, revenue from selling products or services during testing, and the related costs, must be recognised in profit or loss. They cannot be used to reduce the cost of PPE. This approach aims to:
- Avoid artificially lowering the cost of the asset and thereby reducing future depreciation
- Present the revenue and related costs transparently in profit or loss, improving comparability
- Prevent entities from using differing netting practices that make results hard to compare
The standard also requires appropriate disclosures for such testing revenue and related costs, including their amounts and where they are presented in profit or loss, so that users can understand their nature.
5. Incidental operations during construction: when your construction site becomes a car park
For large construction projects, incidental operations sometimes arise during the construction period. Examples include:
- Leasing unused land as a temporary car park
- Renting part of the site for billboards
- Selling certain by‑products from the construction process
How should the income and expenses from these activities be treated?
Core principle: if it does not help to get the asset ready, it goes to profit or loss
The key question is whether the activity forms part of bringing the asset to the location and condition necessary for it to be capable of operating as intended by management.
- If the answer is “no”, such as using vacant land as a temporary car park, then the purpose is simply to make use of idle resources, not to construct the plant itself. Income and expenses from this incidental operation should be recognised in profit or loss, not used to adjust the cost of PPE.
- Only costs that truly relate to construction itself—such as foundations, structural works, and other necessary build costs—belong in PPE.
Practical tip: separate cost “buckets” in your working papers
In working papers, a common approach is to separate project‑related entries into several “buckets” or detailed schedules:
- Direct construction costs (capitalised)
- Testing‑related costs (capitalised only if required to bring the asset to its intended condition)
- Income and expenses from incidental operations (recognised directly in profit or loss)
This segregation makes it easier later to track what has been capitalised and what has gone through profit or loss, and it helps you respond to audit queries about the capitalisation policy.
6. A full case study: building a new factory and classifying all the costs
Let’s pull everything together in one scenario that resembles a real engagement.
Assume Entity A is building a new factory in Tuen Mun and, during the period, incurs the following costs and income (simplified):
- Contract price for land purchase and factory construction: HK$50m
- Architect and engineering consulting fees: HK$3m
- Site clearance and demolition of old buildings: HK$2m
- Salaries of the dedicated engineering project team: HK$1.5m
- Allocated portion of administrative management salaries: HK$0.8m
- Testing of equipment after the plant is built (materials and labour): HK$0.7m
- Revenue from sale of products produced during testing: HK$0.4m
- Cost of sales related to those testing products (materials and processing): HK$0.25m
- Income from renting part of the site as a temporary car park during construction: HK$0.3m
- Related security and maintenance costs for the car park: HK$0.1m
- Present value of dismantling equipment and restoring the site in 20 years: HK$1m
Based on the principles discussed above, the classification could look like this:
Amounts to capitalise as cost of PPE
- Contract price for land and factory: HK$50m
- Architect and engineering consulting fees: HK$3m
- Site clearance and demolition of old buildings (necessary for building the factory): HK$2m
- Salaries of the dedicated engineering team (directly attributable): HK$1.5m
- Testing costs required to bring equipment to its intended operating condition: HK$0.7m
- Present value of dismantling and restoration obligation: HK$1m
Total to be capitalised: HK$58.2m.
Amounts to be expensed in profit or loss
- Allocated administrative management salaries: HK$0.8m (general overhead)
- Revenue from sale of testing products: HK$0.4m (presented as revenue)
- Cost of sales related to those testing products: HK$0.25m (presented as cost of sales or similar)
- Temporary car park income: HK$0.3m (other income or operating revenue)
- Security and maintenance costs for the car park: HK$0.1m (related operating expenses)
Points worth remembering from this case:
- Testing‑phase revenue and related costs both go through profit or loss; they are not netted off against PPE.
- Income and expenses from the temporary car park relate to incidental operations, not to constructing the factory, so they also stay in profit or loss.
- The dismantling and restoration obligation will be paid in the future, but the obligation arises at the time the entity invests in the factory, so it must be capitalised and recognised as a liability upfront.
If you follow this framework, long-term construction projects with many invoices become easier to handle: you decide, for each item, which “bucket” it belongs to.
7. Using a cost framework to read HKAS 16
The cost requirements in HKAS 16 may look like technical details, but they directly affect asset size, depreciation and profit. Next time you are faced with a stack of construction invoices, testing costs and incidental income, ask yourself:
- Is this expenditure necessary to bring the asset to the condition required for it to operate as intended by management?
- Is it directly linked to acquiring or constructing a specific PPE item, rather than simply supporting general business operations or brand building?
- Does it relate to a present obligation to dismantle or restore the site in the future?
- If it is income, does it arise from incidental operations or from selling items produced during testing? If yes, it should be presented transparently in profit or loss, not used to adjust PPE cost.
Once you internalise this logic, your working papers will naturally become more structured: each cost will be accompanied by a brief explanation of why it is capitalised or expensed. You will also become more sensitive when reading financial statement notes, especially around capitalisation policies and disclosures of testing revenue.
If you want to go further into HKAS 16 / IAS 16 after this, good next steps include: choosing depreciation methods, understanding the revaluation model, and linking PPE to impairment testing under HKAS 36, so you can build a complete PPE “toolkit”.
Key takeaways for students and junior accountants
- When you see a construction or equipment project, start by sorting every line item into buckets: purchase price, directly attributable costs, decommissioning obligations, start-up/marketing/admin, testing revenue and incidental operations. This helps you decide capitalisation vs expense consistently.
- In exams and in practice, examiners and reviewers love to see clear explanations of “why” a cost is capitalised or expensed, so always tie your conclusion back to whether it is necessary to bring the asset to its intended operating condition.
- Watch out for three frequent mistakes: capitalising general admin and start-up costs, netting testing revenue against asset cost, and forgetting to include restoration obligations in PPE.
- When reviewing contracts (construction contracts, leases or environmental requirements), highlight any clauses on dismantling, removing or restoring assets, because they often create provisions that must be capitalised under HKAS 16 / IAS 16.
- When preparing working papers, document for each material item: the nature of the cost or income, which “bucket” it belongs to, and a short HKAS 16 / IAS 16‑based reason; this makes audit discussions smoother and strengthens your professional judgment early in your career.
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