When Closing the Books for 2005
—when do you capitalize, when do you expense?

You believe that a substantial expenditure should be capitalized, but your boss wants to expense it. Which is correct? As a member, you can get answers to questions like these every day by calling our free Member AnswerLine. It's just another benefit of membership (www.aipb.org/member_benefits.html) in the American Institute of Professional Bookkeepers.

When several members ask the same question, we publish the answer in The General Ledger (www.aipb.org/general_ledger.html), the free monthly technical update for members.

Now, here is the answer to the question on when to capitalize and when to expense.

Plant and equipment are capitalized and depreciated over future years and are reported at their book value, which is calculated as follows:

Book Value = Cost – Accumulated Depreciation

Sometimes a substantial amount must be spent on an asset for one or more of the following:

1. repairs,
2. improvements and replacements,
3. rearrangements and reinstallations, or
4. additions.


How are these accounted for?

Repairs

Repairs may be ordinary (i.e., recurring) or extraordinary (i.e., nonrecurring).

Ordinary Repairs: Normal, scheduled repairs to keep plant assets in operating condition are a period expense (charged in the period incurred), because the main benefit of the repairs and maintenance is in that period. Examples of period expenses include scheduled cleanings, equipment lubrication, replacement of minor parts, adjustment of equipment, and repainting. The usual entry is:

Repairs and Maintenance XXX

Cash (or Liability) XXX

Extraordinary Repairs: If the repair is of a material nature—a major overhaul, or the repair of a major component of a machine—the amount is capitalized (added to the machine cost) because the benefit is for more than the current period. How the amount is recorded—as an improvement, replacement, or addition—depends on what it was for.

Consequences of mistakes: If an asset is improperly capitalized—a repair cost is capitalized instead of expensed—assets will be overstated and, because no expense is recorded, net income will be understated. If an asset is improperly expensed, assets will be understated, and net income will be overstated.

Improvements v. Replacements It can be difficult to distinguish between an improvement (or “betterment”) v. the replacement of an asset. Generally, an improvement is substituting a better asset (say, a concrete floor for a wooden floor) while a replacement is substituting a similar asset (a wooden floor for a wooden floor).

An improvement or replacement benefits future periods and therefore should be capitalized, using one of three methods, taking into account the asset’s life and better quality and improved quantity provided by the asset.

Method 1: Reduce Accumulated Depreciation: If the asset’s useful life is extended, regardless of quality or quantity, debit Accumulated Depreciation and credit Cash or a liability account. This method raises the book value of the asset by an amount equal to the cost of the improvement or replacement. This is generally how replacements are recorded.

Example: Equipment that cost $100,000 and now has 5 years left on its useful life and accumulated depreciation of $60,000 has an engine replaced for $15,000. The replacement is expected to extend the equipment’s life to 10 years. The entry is:

Accumulated Depreciation 15,000 Cash (or Liability) 15,000

Old book value: $100,000 – $60,000 = $40,000

New book value: $100,000 – $45,000 = $55,000

New yearly depreciation expense: $ 55,000/10 years = $5,500/year

Method 2: Increase the asset account: If the asset’s quantity or quality of is enhanced (generally an improvement), the cost is capitalized by being added to the original cost, assuming that the asset’s life is not extended.

Example: A machine with an original cost of $50,000 now has $30,000 in accumulated depreciation, 5 years left on its life, and produces 4,000 parts an hour. New equipment that costs $5,000 is attached to the machine, increasing its output to 6,000 parts per hour, but not extending the machine’s life. The entry is:

Machine 5,000

Cash (or Liability) 5,000

Old book value: $50,000 – $30,000 = $20,000

New book value: $55,000 – $30,000 = $25,000

New yearly depreciation expense: $25,000/5 years = $5,000/year

Method 3: Establish a new asset account: If the new asset replaces an old one, a new asset account may be appropriate, assuming that the comparable old unit has been disposed of and any loss recognized. Thus, two more entries are required.

Example: A $10,000 roof 80% depreciated is replaced with a new one costing $15,000. The two entries are:

Accumulated Depreciation 8,000

Loss 2,000

Asset (old unit) 10,000

To remove old asset

New Roof 15,000

Cash 15,000

To record replacement of asset

If the original acquisition cost and subsequent depreciation of separate components can be figured out, each component can be valued and allocated as a separate asset. But this is not usually done, so expenditures for major component replacements are usually recorded by reducing accumulated depreciation or increasing the old asset account.

Questionable Situations If a replacement or an improvement extends an asset’s life and improves its quantity or quality, which method should you use? Methods 1 and 2 increase the asset’s book value—but the extended life is generally recorded by reducing accumulated depreciation. Therefore, if a replacement or an improvement extends the life of an asset and improves productive quantity or quality, it is accounted for using Method 1 (Reducing Accumulated Depreciation).

Rearrangements and Reinstallations

The movement of assets from one location to another (e.g., to streamline work flow) can be costly. But because future periods benefit, these costs are capitalized, as follows:

1. If the original installation cost is known, treat the expenditure like a replacement: Remove the book value of the original installation and depreciate the expenditure over the asset’s remaining life.

Asset (new unit) XXX

Accumulated Depreciation XXX

Cash (or Liability) XXX

Asset (old unit) XXX

2. If the original installation cost is unknown, create a new asset account for it and depreciate the expenditure over the expected number of periods that will benefit from the rearrangement or reinstallation.

Asset (New) XXX

Cash (or Liability) XXX

Additions

If an addition creates a new asset—e.g., a floor added to the top of an office building—its value is added to the current asset’s undepreciated cost (book value) and depreciated over the underlying asset’s remaining life. All costs associated with the addition (e.g., tearing down a wall to add a wing) are included with the other costs of the addition.

Asset XXX

Cash (or Liability) XXX

Summary

Expenditures that are made after an asset is purchased and that create a benefit primarily in the period made are expensed; expenditures that create a benefit in future periods are capitalized. For a material expenditure, determine the method to account for it. If not material, expense it.


Source: American Institute of Professional Bookkeepers
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