Accounting: The Language of Business (Part 61)

The U.S. tax code was written by A students. Every April 15, we have to pay somebody who got an A in accounting to keep ourselves from being sent to jail.

P. J. O'Rourke

Fixed Assets and Intangible Assets (Part E)

by

Charles Lamson

Capital and Revenue Expenditures

The costs of acquiring fixed assets, adding to a fixed asset, improving a fixed asset, or extending a fixed asset's useful life are called capital expenditures. Such expenditures are recorded by either debiting the asset account or its related accumulated depreciation account. Costs that benefit only the current period or costs incurred for normal maintenance and repairs are called revenue expenditures. Such expenditures are debited to expense accounts. For example, the cost of replacing spark plugs in an automobile or the cost of repainting a building should be debited to an expense account.

To properly match revenues and expenses, it is important to distinguish between capital and revenue expenditures. Capital expenditures will affect the depreciation expense of more than one period, while revenue expenditures will affect the expenses of only the current period.

Stages of Acquiring Fixed Assets

The costs incurred for fixed assets can be classified into four stages: preliminary, preacquisition, acquisition or construction, and in-service. These stages are illustrated in Exhibit 7.

EXHIBIT 7 Fixed Asset Project Stages

The preliminary stage occurs before management believes acquiring a fixed asset is probable. During the stage, a company may conduct feasibility studies, marketing studies, and financial analyses to determine the viability of a fixed asset acquisition. These costs are not associated with a particular fixed asset, so must be treated as revenue expenditures.

In the preacquisition stage, acquiring the fixed asset has become probable, but has not yet occurred. Costs that are incurred during this stage, such as surveys, zoning, and engineering studies, can be associated with a specific fixed asset and should be treated as a capital expenditure. As we stated previously, Capital expenditures are the costs of acquiring, constructing, adding, or replacing fixed assets.

During the acquisition or construction stage, the acquisition has occurred or construction has begun, but the fixed asset is not yet ready for use. Costs directly identified with the fixed asset during the stage should be capitalized in the fixed asset account or in a construction in progress account. General and administrative costs should not be allocated to fixed asset acquisition or construction for capitalization. These costs are debited to the appropriate general and administrative expense account. When the fixed asset is ready for use, the capitalized costs should be transferred from construction in progress to the related fixed asset account. 

During the in-service stage, the fixed asset is complete and ready for use. During this stage, the fixed asset should be depreciated as described in the previous section. In addition, normal, recurring, or periodic repairs and maintenance activities related to fixed assets during this stage should be charged to maintenance expense for the period. Costs incurred to either acquire additional components of fixed assets or replace existing components of fixed assets should be capitalized, as described in the next section.

Exhibit 8 summarizes the accounting for capital and revenue expenditures for the four stages of acquiring fixed assets.

EXHIBIT 8 Capital and Revenue Expenditures

Fixed-Asset Components

An in-service stage fixed asset often includes one or more components. A component is a tangible portion of a fixed asset that can be separately identified as an asset and depreciated over its own separate expected useful life. For example, the roof or elevator of a building could be identified as components that are depreciated separately from the building itself. When a company acquires or constructs a new component, the costs should be capitalized as described for the previous project stages. Once installed, the component would be depreciated over its useful service life. For example, on April 1, Boxter Company purchased and installed a new crane within a warehouse for $150,000. This cost would be capitalized as a separate component as follows:

The company can also replace a component. Replacements are accounted for in two steps. First, the book value of the replaced component is debited to Depreciation Expense and credited to Accumulated Depreciation. This treatment is consistent with a change of estimate, that is, the fixed asset component is now recognized as being fully depreciated upon replacement. In addition, any costs to remove the old component should be charged to expense. Second, the identifiable direct costs associated with the new component are then capitalized. To illustrate, assume that Boxter removes a warehouse roof on August 1 at a cost of $1,000. As of August 1, the old roof has a remaining book value ($40,000 initial cost less $31,000 accumulated depreciation) of $9,000. On August 5, the new roof is completed at a cost of $60,000 and is estimated to have a 20-year life, which is the remaining life of the building. First, the cost of removing the old roof must be expensed, and the book value of the replaced roof must be completely depreciated, as follows:

After the preceding entry, the book value of the old roof is 0 ($40,000 cost less $40,000 accumulated depreciation). Since the old roof is being replaced, its cost and related depreciation must now be removed from the accounting records, as shown in the following entry:

Next, the cost of the new roof must be capitalized as a separate component as follows:

Using the straight-line method (from part 58), the new roof will be depreciated over 20 years at $3,000 per year ($60,000 / 20 years).

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 402-404*

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