After a long term asset such as property, plant and equipment has been acquired by a business, additional costs are often incurred which need to be classified as either capital improvements or repairs and maintenance expenses.
The nature and classification of the costs as capital or repairs is important in accounting as capital improvements will be added to the original cost of the asset, included in the balance sheet, and depreciated over their useful life, whereas repairs will be treated as an expense of the business and included in the income statement for the year.
Each business will normally have a capitalization policy, for example a business might decide that expenditure must be greater than 3,000 and the useful life be greater than one year before being considered as capital expenditure.
Assuming the capitalization policy is satisfied, costs can normally be considered as capital improvements and added to the original capitalized cost of an asset for the following reasons.
- The asset is larger after the additional costs have be incurred such as for example, the addition of an extension to a building.
- The asset is improved beyond its earlier condition by the expenditure, making it for example more efficient to operate or more productive than when it was originally purchased,
- The asset is given an extended useful life by the expenditure.
Repairs and Maintenance Costs
Repairs and maintenance costs normally fall under the same expense heading. The distinction between the two is that a repair is undertaken to fix damage to an asset whereas maintenance is undertaken to prevent damage.
These costs are incurred to either return the asset to its earlier condition or maintain the asset in its current condition and do not improve it beyond that. In these circumstances they do not satisfy the capital improvement criteria listed above and therefore the cost is treated as an expense in the income statement of the business in the current year.
Capital Improvements and Repairs Example
Suppose a business incurs costs of 5,000 in installing network and fiber optic cabling in its office premises. The business has a policy to capitalize appropriate costs over 500 where the asset has a useful life of greater than one year.
The expenditure satisfies the capitalization policy of the business as it is over 500 and has a useful life greater than one year. Since the cabling has improved the building beyond its original state making it, among other things, more efficient, the cost is treated as a capital item and included in the balance sheet of the business.
The following capital improvements journal would be used to record the cost
|Property, plant, and equipment||5,000|
The 5,000 capital improvement cost is posted to a balance sheet account (property, plant and equipment). In subsequent years the capitalized cost amount will be depreciated over its useful life.
Repairs and Maintenance
In addition, the business incurs costs of 600 in carrying out repairs to electrical wiring.
Although the costs incurred are greater than the capitalization policy limit of the business, they simply return the electrical wiring to its normal condition and do not improve it beyond its original state. In these circumstances the costs are treated as an expense of the business and included in the income statement as a repairs expense.
The journal to post the expense is as follows.
The cost of 600 is posted to an income statement account (repairs expense) and reduces the net income of the business for the year.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.