Most operating assets require expenditures to repair, maintain, or improve them. These subsequent costs can pose accounting problems if they are material in amount or significantly affect the asset’s service life. In general terms, the accountant faces the choice between capitalizing the expenditure by increasing the asset’s book value or expensing it in the year in which it occurs.
Conceptually, the best treatment would call for capitalization of all expenditures that yield benefits beyond the end of the fiscal year. However, the practical problems of implementing this policy often preclude its being used. The most obvious problem is the lack of objective criteria for determining whether and how long the benefit will last into the future.
To deal with these problems where their impact is material, general practice uses these four classes of expenditures:
- Ordinary repairs—expenditures made to keep the asset’s usefulness at an appropriate level; adds to neither the useful life nor the capability of the asset.
- Extraordinary repairs—expenditures made to improve the asset’s usefulness Includes:
a. Replacements—expenditures made to substitute a new major component for an existing one; typically extends the asset’s useful life but not its capability.
b. Improvements—expenditures made to substitute a new improved major component for an existing one; typically extends the asset’s useful life and increases its capability.
- Additions—expenditures made to add a new major component to an existing asset; typically adds to the asset’s capability but does not extend its useful life.
- Rearrangements—expenditures made to restructure the asset without addition, replacement, or improvement; goal is to create new capability but not necessarily extend useful life.
It should be noted that there are no clear dividing lines between these classifications. General practice has developed some common treatments of these classes of expenditures. They involve either expensing or capitalizing the expenditures.
Expense—amount spent reduces income of present period only; typically applied to ordinary repairs; for example:
Capitalize—book value of the asset is increased by the amount of the expenditure; reduces income in future periods through its effect on depreciation expense. It can be accomplished through one of the following approaches:
a. Accumulated depreciation—-amount spent is taken directly out of accumulated depreciation; typically applied to replacements; for example:
b. Asset and accumulated depreciation—amount spent is divided between asset account and accumulated depreciation; typically applied to improvements; size of debit to accumulated depreciation is amount charged in prior periods on the removed component; for example:
c. Asset (gross)—amount spent is added to the asset account; typically applied to additions and rearrangements; for example:
These rules are not uniformly followed and have never been addressed in authoritative pronouncements. However, there are few abuses because the amounts involved are often immaterial.
Following example summarizes the categories of expenditures, their effects, and their typical treatment.