Most operating assets require expenditures for repairs, maintenance, or improvements. These subsequent costs can pose accounting problems if they are material in amount or significantly affect the asset’s service life.
In general terms, an accountant must choose 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 use. 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, it is common in general practice to use the following four classes of expenditures:
- Ordinary repairs: Expenditures made to keep the asset’s usefulness at an appropriate level, and which contribute to neither the useful life nor the capability of the asset.
- Extraordinary repairs: Expenditures made to improve the asset’s usefulness, including:
- Replacements: Expenditures made to substitute a new major component for an existing one, typically extending the asset’s useful life but not its capability.
- Improvements: Expenditures made to substitute a new, improved, major component for an existing one, typically extending the asset’s useful life and increasing its capability.
- Additions: Expenditures made to add a new major component to an existing asset, typically adding to the asset’s capability but not extending its useful life.
- Rearrangements: Expenditures made to restructure an asset without addition, replacement, or improvement, where the goal is to create new capabilities but not necessarily extend useful life.
Importantly, 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: The amount spent reduces the present period’s income only, and it is typically applied to ordinary repairs. For example:
Capitalize: The asset’s book value is increased by the amount of the expenditure, which reduces income in future periods through its effect on depreciation expense. This can be achieved using one of the following approaches:
1. Accumulated depreciation: The amount spent is taken directly out of accumulated depreciation. This is typically applied to replacements. For example:
2. Asset and accumulated depreciation: The amount spent is divided between the asset account and accumulated depreciation. This is typically applied to improvements.
Also, the size of the debit to accumulated depreciation is the amount charged in prior periods on the removed component. An example is shown below.
3. Asset (gross): The amount spent is added to the asset account. This is typically applied to additions and rearrangements. For example:
These rules are not uniformly followed. Furthermore, they have never been addressed in the guidelines or pronouncements of any official body or agency. However, there are few cases of abuse due to the fact that the amounts involved are often immaterial.
A summary of the categories of expenditures, their effects, and their typical treatment is given below.