Costs related to plant assets that are incurred after the asset is placed in use are either added to the fixed asset account (capitalized) or charged against operations (expensed) when incurred. In this article, we will discuss underlying principles for this accounting event.
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. The FA accountant faces the choice between capitalizing and expensing it in the year in which it occurs.
The cost of an item of the fixed asset comprises its purchase price, including import duties and other non-refundable taxes or levies and any directly attributable cost of bringing the asset to its working condition for its intended use; any trade discounts and rebates are deducted in arriving at the purchase price.
Examples of directly attributable costs are:
The cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustments, changes in duties, or similar factors.
Administration and other general overhead expenses are usually excluded from the cost of fixed assets because they do not relate to a specific fixed asset. However, in some circumstances, such expenses as are specifically attributable to the construction of a project or to the acquisition of a fixed asset or bringing it to its working condition may be included as part of the cost of the construction project or as a part of the cost of the fixed asset. The expenditure incurred on start-up and commissioning of the project, including the expenditure incurred on test runs and experimental production, is usually capitalized as an indirect element of the construction cost. However, the expenditure incurred after the plant has begun commercial production, i.e., production intended for sale or captive consumption, is not capitalized and is treated as revenue expenditure even though the contract may stipulate that the plant will not be finally taken over until after the satisfactory completion.
If the interval between the date a project is ready to commence commercial production and the date at which commercial production actually begins is prolonged, all expenses incurred during this period are charged to the profit and loss statement. However, the expenditure incurred during this period is also sometimes treated as deferred revenue expenditure to be amortized over a period not exceeding 3 to 5 years after the commencement.
Rearrangement and reinstallation costs are generally carried forward as a separate asset and amortized against future income.
Additions are the 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. Additions result in the creation of new assets, they should be capitalized. The cost of an addition or extension to an existing asset which is of a capital nature and which becomes an integral part of the existing asset is usually added to its gross book value. Any addition or extension, which has a separate identity and is capable of being used after the existing asset is disposed of, is accounted for separately
Improvements and replacements are substitutions of one asset for another. Improvements substitute a better asset for the one currently used, whereas a replacement substitutes a similar asset. The major problem in accounting for improvements and replacements concerns differentiating these expenditures from normal repairs.
Improvements & substitutions may fall in one of the below:
1. 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.
2. Extraordinary Repairs
Expenditures made to improve the asset’s usefulness Includes:
Expenditures made to substitute a new major component for an existing one; typically extends the asset’s useful life but not its capability.
Expenditures made to substitute a new improved major component for an existing one; typically extends the asset’s useful life and increases its capability.
Expenditures made to restructure the asset without addition, replacement, or improvement; the goal is to create new capability but not necessarily extend useful life.
A truck may have an engine that is in need of replacement. The replacement of the engine represents a “restoration” of some of the original condition (akin to “un-depreciating”). Restoration and improvement type costs are considered to meet the conditions for capitalization because of the enhancement of service life/quality.
(a) The useful life of the asset must be increased/extended. For example, the expected service life of the asset is long after the investment.
(b) The quantity of service produced from the asset must be increased. The capacity or productivity of the equipment increases. The units of output are higher.
(c) The quality of the units produced must be enhanced. The quality of output is enhanced in some manner. The units produced contain functionality that was not present prior to the investment.
In general, costs incurred to achieve greater future benefits from the asset should be capitalized. It should be capitalized only if an improvement or replacement increases the future service potential of the asset.
(a) Substituting the cost of the new asset for the cost of the asset replaced,
(b) Capitalizing the new cost without eliminating the cost of the asset replaced, or
(c) Debiting the expenditure to accumulated depreciation.
Frequently, it is difficult to determine whether subsequent expenditure related to fixed asset represents improvements that ought to be added to the gross book value or repairs that ought to be charged to the profit and loss statement. Only expenditure that increases the future benefits from the existing asset beyond its previously assessed standard of performance is included in the gross book value, e.g., an increase in capacity. The specific facts related to the situation will aid in determining the most appropriate method to use.
Expenditures that simply maintain a given level of service such as normal repairs should be expensed. Subsequent expenditures related to an item of a fixed asset should be added to its book value only if they increase the future benefits from the existing asset beyond its previously assessed standard of performance.
Most items of PP&E require substantial ongoing costs to keep them in good order. The accounting rules for such costs treat them as “capital expenditures” if future economic benefits result from the expenditure. Future economic benefits occur if the service life of an asset is prolonged, the quantity of services expected from an asset is increased, or the quality of services expected from an asset is improved.
In many instances, a considerable amount of judgment is required in deciding whether to capitalize or expense an item. However, the consistent application of a capital/expense policy is normally more important than attempting to provide theoretical guidelines.