Reading: Lesson 5 - Subsequent expenditures (capital and revenue) on assets

Companies often spend additional funds on plant assets that have been in use for some time. They debit these expenditures to: (1) an asset account; (2) an accumulated depreciation account; or (3) an expense account. Expenditures debited to an asset account or to an accumulated depreciation account are capital expenditures. Capital expenditures increase the book value of plant assets. Revenue expenditures, on the other hand, do not qualify as capital expenditures because they help to generate the current period's revenues rather than future periods' revenues. As a result, companies expense these revenue expenditures immediately and report them in the income statement as expenses.

Betterments or improvements to existing plant assets are capital expenditures because they increase the quality of services obtained from the asset. Because betterments or improvements add to the service-rendering ability of assets, firms charge them to the asset accounts. For example, installing an air conditioner in an automobile that did not previously have one is a betterment. The debit for such an expenditure is to the asset account, Automobiles.

Occasionally, expenditures made on plant assets extend the quantity of services beyond the original estimate but do not improve the quality of the services. Since these expenditures benefit an increased number of future periods, accountants capitalize rather than expense them. However, since there is no visible, tangible addition to, or improvement in, the quality of services, they charge the expenditures to the accumulated depreciation account, thus reducing the credit balance in that account. Such expenditures cancel a part of the existing accumulated depreciation; firms often call them extraordinary repairs.

To illustrate, assume that after operating a press for four years, a company spent USD 5,000 to recondition the press. The reconditioning increased the machine's life to 14 years instead of the original estimate of 10 years. The journal entry to record the extraordinary repair is:

Originally, the press cost USD 40,000, had an estimated useful life of 10 years, and had no estimated salvage value. At the end of the fourth year, the balance in its accumulated depreciation account under the straight-line method is [(USD 40,000/10) X 4] = USD 16,000. After debiting the USD 5,000 spent to recondition the press to the accumulated depreciation account, the balances in the asset account and its related accumulated depreciation account are as shown in the last column:

In effect, the expenditure increases the carrying amount (book value) of the asset by reducing its contra account, accumulated depreciation. Under the straight-line method, we would divide the new book value of the press, USD 29,000, equally among the 10 remaining years in amounts of USD 2,900 per year (assuming that the estimated salvage value is still zero). As a practical matter, expenditures for major repairs not extending the asset's life are sometimes charged to accumulated depreciation. This avoids distorting net income by expensing these expenditures in the year incurred. Then, firms calculate a revised depreciation expense, and spread the cost of major repairs over a number of years. This treatment is not theoretically correct.

To illustrate, assume the same facts as in the previous example except that the USD 5,000 expenditure did not extend the life of the asset. Because of the size of this expenditure, the company still charges it to accumulated depreciation. Now, it would spread the USD 29,000 remaining book value over the remaining six years of the life of the press. Under the straight-line method, annual depreciation would then be (USD 29,000/6) = USD 4,833.

Accountants treat as expenses those recurring and/or minor expenditures that neither add to the asset's service-rendering quality nor extend its quantity of services beyond its original estimated useful life. Thus, firms immediately expense regular maintenance (lubricating a machine) and ordinary repairs (replacing a broken fan belt on an automobile) as revenue expenditures. For example, a company that spends USD 190 to repair a machine after using it for some time, debits Maintenance Expense or Repairs Expense.

Low-cost items Most businesses purchase low-cost items that provide years of service, such as paperweights, hammers, wrenches, and drills. Because of the small dollar amounts involved, it is impractical to use the ordinary depreciation methods for such assets, and it is often costly to maintain records of individual items. Also, the effect of low-cost items on the financial statements is not significant. Accordingly, it is more efficient to record the items as expenses when they are purchased. For instance, many companies charge any expenditure less than an arbitrary minimum, say, USD 100, to expense regardless of its impact on the asset's useful life. This practice of accounting for such low unit cost items as expenses is an example of the modifying convention of materiality that was discussed in Chapter 5. In Exhibit 12, we summarize expenditures on plant assets after acquisition.

In practice, it is difficult to decide whether to debit an expenditure to the asset account or to the accumulated depreciation account. For example, some expenditures seem to affect both the quality and quantity of services. Even if the wrong account were debited for the expenditure, the book value of the plant asset at that point would be the same amount it would have been if the correct account had been debited. However, both the asset and accumulated depreciation accounts would be misstated. As an example of the effect of misstated asset and accumulated depreciation accounts, assume Watson Company had an asset that had originally cost USD 15,000 and had been depreciated to a book value of USD 6,000 at the beginning of 2010. At that time, Watson estimated the equipment had a remaining useful life of two years. The company spent USD 4,000 in early January 2010 to install a new motor in the equipment. This motor extended the useful life of the asset four years beyond the original estimate. Since the expenditure extended the life, the firm should capitalize it by a debit to the accumulated depreciation account. We show the calculations for depreciation expense if the entry was made correctly and if the expenditure had been improperly charged (debited) to the asset account in Exhibit 13.

If an expenditure that should be expensed is capitalized, the effects are more significant. Assume now that USD 6,000 in repairs expense is incurred for a plant asset that originally cost USD 40,000 and had a useful life of four years and no estimated salvage value. This asset had been depreciated using the straight-line method for one year and had a book value of USD 30,000 (USD 40,000 cost—USD 10,000 first-year depreciation) at the beginning of 2010. The company capitalized the USD 6,000 that should have been charged to repairs expense in 2010. The charge for depreciation should have remained at USD 10,000 for each of the next three years. With the incorrect entry, however, depreciation increases.

Regardless of whether the repair was debited to the asset account or the accumulated depreciation account, the firm would change the depreciation expense amount to USD 12,000 for each of the next three years [(USD 30,000 book value + USD 6,000 repairs expense)/3 more years of useful life]. These errors would cause net income for the year 2010 to be overstated USD 4,000: (1) repairs expense is understated by USD 6,000, causing income to be overstated by USD 6,000; and (2) depreciation expense is overstated by USD 2,000, causing income to be understated by USD 2,000. In 2011, the overstatement of depreciation by USD 2,000 would cause 2011 income to be understated by USD 2,000. Note that the USD 6,000 recording error affects more than just the expense accounts and net income. Plant asset and Retained Earnings accounts on the balance sheet also reflect the impact of this error. To see the effect of incorrectly capitalizing the USD 6,000 to the asset account rather than correctly expensing it, look at Exhibit 14.