8.10 Capital and Revenue Expenditures

Establishing Original Asset Cost

  • The chapter primarily focuses on determining the original cost of an asset.
    • Considerations include outright purchases, asset class (land, building), interest costs, long-term financing, lump-sum purchases, equity exchanges, non-monetary exchanges, and donations.

Capital vs. Revenue Expenditures

  • When managing long-lived assets, additional costs arise after the asset is in service, requiring classification as either capital or revenue expenditures.
  • Capital Expenditure: Costs that enhance the asset's future revenue-generating ability.
    • These costs are added to the asset's book value (capitalized).
  • Revenue Expenditure: Costs for routine maintenance to keep the asset in good working order.

Maintenance and Repairs (Revenue Expenditures)

  • Routine maintenance costs are treated as revenue expenditures.
  • Example: Oil changes and tire rotations for delivery trucks (e.g., UPS, FedEx) are recorded as maintenance and repairs expense in the period incurred.
    • Debit: Maintenance and Repairs Expense
    • Credit: Accounts Payable or Cash

Capital Expenditures: Enhancing Asset Value

  • Capital expenditures increase the asset's useful life or productivity.
    • Rebuilding an engine extends the useful life of a delivery truck. This would be treated as a capital expenditure.
    • Enhancements increase output quantity or product quality.
  • Capital expenditures benefit future periods by:
    • Increasing productivity.
    • Enhancing product quality.
    • Extending the asset's useful life.
    • Reducing production costs.

Accounting Treatment for Capital Expenditures

  • Capitalize the new cost by adding it to the asset's book value on the balance sheet.
  • Restructure depreciation over the asset's remaining useful life.
  • Straight-Line Depreciation Method Adjustment:
    • Adjust depreciation based on the new book value, salvage value (if changed), and remaining useful life.

Compliance and Unexpected Costs

  • Compliance with Laws: Material expenditures to update an asset to meet federal or state laws are treated as capital expenditures.
  • Accidents, Neglect, or Theft: Subsequent expenditures resulting from accidents, neglect, abuse, or theft are recognized as an expense or loss in the period incurred.

Practice Problem: Sparky Plant Facility

  • Sparky's plant facility is 10 years old with a 30-year life and a 200,000 salvage value; straight-line depreciation is used.
  • The current book value is 1,000,000, based on an original cost of 1,400,000 less 400,000 in accumulated depreciation.

Expenditures in Year 2

  1. Roof Replacement: Replacing an asbestos cement slate roof with a wood shingle roof to comply with federal safety regulations cost 65,000. Since this is required for compliance and is a material amount, it is treated as a capital expenditure and added to the book value.
  2. Electrical System Update: Updating the electrical system cost 45,000 and will generate cost savings. This is considered a capital expenditure because it changes future cash flows.
  3. Plant Repainting: Repainting the plant cost 23,000. This is routine maintenance and is treated as a revenue expenditure.

Depreciation Restructuring

  • Expenditures 1 and 2 are capital expenditures, while 3 is a revenue expenditure.
  • Restructuring Depreciation for Year 2:
    • Original Book Value: 1,000,000
    • Roof Replacement: 65,000
    • Electrical System: 45,000
    • Total Capital Expenditures: 110,000
    • New Book Value: 1,110,000
    • Salvage Value: 200,000
    • Remaining Useful Life: 20 years
    • Annual Depreciation = \frac{New Book Value - Salvage Value}{Remaining Useful Life}
      Annual Depreciation = \frac{1,110,000 - 200,000}{20} = 45,500
  • Annual depreciation is now 45,500 for the remaining 20 years.