When a business purchases a long-term asset (used for more than
one year), it classifies the asset based on whether the asset is
used in the business’s operations. If a long-term asset is used in
the business operations, it will belong in property, plant, and
equipment or intangible assets. In this situation the asset is
typically capitalized. Capitalization is the
process by which a long-term asset is recorded on the balance sheet
and its allocated costs are expensed on the income statement over
the asset’s economic life.
Explain and Apply Depreciation Methods to Allocate Capitalized
Costs addresses the available methods that companies may
choose for expensing capitalized assets.
Long-term assets that are not used in daily operations are
typically classified as an investment. For example, if a business
owns land on which it operates a store, warehouse, factory, or
offices, the cost of that land would be included in property,
plant, and equipment. However, if a business owns a vacant piece of
land on which the business conducts no operations (and assuming no
current or intermediate-term plans for development), the land would
be considered an investment.
YOUR TURN
You work at a business consulting firm. Your new colleague,
Marielena, is helping a client organize his accounting records by
types of assets and expenditures. Marielena is a bit stumped on how
to classify certain assets and related expenditures, such as
capitalized costs versus expenses. She has given you the following
list and asked for your help to sort through it. Help her classify
the expenditures as either capitalized or expensed, and note which
assets are property, plant, and equipment.
Expenditures:
- normal repair and maintenance on the manufacturing
facility
- cost of taxes on new equipment used in business operations
- shipping costs on new equipment used in business
operations
- cost of a minor repair on existing equipment used in business
operations
Assets:
- land next to the production facility held for use next year as
a place to build a warehouse
- land held for future resale when the value increases
- equipment used in the production process
Solution
Expenditures:
- normal repair and maintenance on the manufacturing facility:
expensed
- cost of taxes on new equipment used in business operations:
capitalized
- shipping costs on new equipment used in business operations:
capitalized
- cost of a minor repair on existing equipment used in business
operations: expensed
Assets:
- land next to the production facility held for use next year as
a place to build a warehouse: property, plant, and equipment
- land held for future resale when the value increases:
investment
- equipment used in the production process: property, plant, and
equipment
Property, Plant, and Equipment (Fixed Assets)
Why are the costs of putting a long-term asset into service
capitalized and written off as expenses (depreciated) over the
economic life of the asset? Let’s return to Liam’s start-up
business as an example. Liam plans to buy a silk-screening machine
to help create clothing that he will sell. The machine is a
long-term asset, because it will be used in the business’s daily
operation for many years. If the machine costs Liam $5,000 and it
is expected to be used in his business for several years, generally
accepted accounting principles (GAAP) require the allocation of the
machine’s costs over its useful life, which is the period over
which it will produce revenues. Overall, in determining a company’s
financial performance, we would not expect that Liam should have an
expense of $5,000 this year and $0 in expenses for this machine for
future years in which it is being used. GAAP addressed this through
the expense recognition
(matching) principle, which states
that expenses should be recorded in the same period with the
revenues that the expense helped create. In Liam’s case, the $5,000
for this machine should be allocated over the years in which it
helps to generate revenue for the business. Capitalizing the
machine allows this to occur. As stated previously, to capitalize
is to record a long-term asset on the balance sheet and expense its
allocated costs on the income statement over the asset’s economic
life. Therefore, when Liam purchases the machine, he will record it
as an asset on the financial statements.
When capitalizing an asset, the total cost of acquiring the
asset is included in the cost of the asset. This includes
additional costs beyond the purchase price, such as shipping costs,
taxes, assembly, and legal fees. For example, if a real estate
broker is paid $8,000 as part of a transaction to purchase land for
$100,000, the land would be recorded at a cost of $108,000.
Over time as the asset is used to generate revenue, Liam will
need to depreciate the asset.
Depreciation is the process of allocating the
cost of a tangible asset over its useful life, or the period of
time that the business believes it will use the asset to help
generate revenue. This process will be described in
Explain and Apply Depreciation Methods to Allocate Capitalized
Costs.
ETHICAL CONSIDERATIONS
How WorldCom’s Improper Capitalization of Costs Almost Shut
Down the Internet
In 2002, telecommunications giant
WorldCom filed for the largest
Chapter 11 bankruptcy to date, a situation resulting from
manipulation of its accounting records. At the time,
WorldCom operated nearly a third
of the bandwidth of the twenty largest US internet backbone routes,
connecting over 3,400 global networks that serviced more than
70,000 businesses in 114 countries.4
WorldCom used a number of
accounting gimmicks to defraud investors, mainly including
capitalizing costs that should have been expensed. Under normal
circumstances, this might have been considered just another account
fiasco leading to the end of a company. However,
WorldCom controlled a large
percentage of backbone routes, a major component of the hardware
supporting the internet, as even the Securities and Exchange
Commission recognized.5
If WorldCom’s bankruptcy due to
accounting malfeasance shut the company down, then the internet
would no longer be functional.
If such an event was to happen today, it could shut down
international commerce and would be considered a national
emergency. As demonstrated by
WorldCom, the unethical behavior
of a few accountants could have shut down the world’s online
businesses and international commerce. An accountant’s job is
fundamental and important: keep businesses operating in a
transparent fashion.
Investments
A short-term or long-term asset that is not used in the
day-to-day operations of the business is considered an
investment and is not expensed, since the company
does not expect to use up the asset over time. On the contrary, the
company hopes that the assets (investment) would grow in value over
time. Short-term investments are investments that are expected to
be sold within a year and are recorded as current assets.
CONTINUING APPLICATION
Investment in Property in the Grocery Industry
To remain viable, companies constantly look to invest in
upgrades in long-term assets. Such acquisitions might include new
machinery, buildings, warehouses, or even land in order to expand
operations or make the work process more efficient. Think back to
the last time you walked through a grocery store. Were you mostly
focused on getting the food items on your list? Or did you plan to
pick up a prescription and maybe a coffee once you finished?
Grocery stores have become a one-stop shopping environment, and
investments encompass more than just shelving and floor
arrangement. Some grocery chains purchase warehouses to distribute
inventory as needed to various stores. Machinery upgrades can help
automate various departments. Some supermarkets even purchase large
parcels of land to build not only their stores, but also
surrounding shopping plazas to draw in customers. All such
investments help increase the company’s net profit.
CONCEPTS IN PRACTICE
Vehicle Repairs and Enhancements
Automobiles are a useful way of looking at the difference
between repair and maintenance expenses and capitalized
modifications. Routine repairs such as brake pad replacements are
recorded as repair and maintenance expense. They are an expected
part of owning a vehicle. However, a car may be modified to change
its appearance or performance. For example, if a supercharger is
added to a car to increase its horsepower, the car’s performance is
increased, and the cost should be included as a part of the vehicle
asset. Likewise, if replacing the engine of an older car extends
its useful life, that cost would also be capitalized.
Repair and Maintenance Costs of Property, Plant, and
Equipment
Long-term assets may have additional costs associated with them
over time. These additional costs may be capitalized or expensed
based on the nature of the cost. For example,
Walmart’s financial statements
explain that major improvements are capitalized, while costs of
normal repairs and maintenance are charged to expense as
incurred.
An amount spent is considered a current
expense, or an amount charged in the current period, if
the amount incurred did not help to extend the life of or improve
the asset. For example, if a service company cleans and maintains
Liam’s silk-screening machine every six months, that service does
not extend the useful life of the machine beyond the original
estimate, increase the capacity of the machine, or improve the
quality of the silk-screening performed by the machine. Therefore,
this maintenance would be expensed within the current period. In
contrast, if Liam had the company upgrade the circuit board of the
silk-screening machine, thereby increasing the machine’s future
capabilities, this would be capitalized and depreciated over its
useful life.
THINK IT THROUGH
Correcting Errors in Classifying Assets
You work at a business consulting firm. Your new colleague,
Marielena, helped a client organize his accounting records last
year by types of assets and expenditures. Even though Marielena was
a bit stumped on how to classify certain assets and related
expenditures, such as capitalized costs versus expenses, she did
not come to you or any other more experienced colleagues for help.
Instead, she made the following classifications and gave them to
the client who used this as the basis for accounting transactions
over the last year. Thankfully, you have been asked this year to
help prepare the client’s financial reports and correct errors that
were made. Explain what impact these errors would have had over the
last year and how you will correct them so you can prepare accurate
financial statements.
Expenditures:
- Normal repair and maintenance on the manufacturing facility
were capitalized.
- The cost of taxes on new equipment used in business operations
was expensed.
- The shipping costs on new equipment used in business operations
were expensed.
- The cost of a minor repair on existing equipment used in
business operations was capitalized.
Assets:
- Land next to the production facility held for use next year as
a place to build a warehouse was depreciated.
- Land held for future resale when the value increases was
classified as Property, Plant, and Equipment but not
depreciated.
- Equipment used in the production process was classified as an
investment.
LINK TO LEARNING
Many businesses invest a lot of money in production facilities
and operations. Some production processes are more automated than
others, and they require a greater investment in property, plant,
and equipment than production facilities that may be more labor
intensive. Watch this video of the
operation of a Georgia-Pacific
lumber mill and note where you see all components of property,
plant, and equipment in operations in this fascinating production
process. There’s even a reference to an intangible asset—if you
watch and listen closely, you just might catch it.