Repairs and maintenance are a routine part of business.
When it comes to record keeping, where you put these costs can have a large impact on your financial results and your tax situation.
What is capitalization?
In its simplest form, capitalization is the process of adding additional costs to the value of the asset.
You collect the value of items that enhance the value of an asset on your balance sheet and then place it in service when repairs are substantially complete.
When that happens, you depreciate the value over the expected life of those repairs, or the remaining life of the asset depending on the circumstances.
The inverse of capitalization would be running the costs through your profit and loss as expense.
The idea behind capitalization is that repairs enhance the lives of real estate or machinery.
Therefore, it is more appropriate to enhance the life (i.e. record an increase in asset value on the balance sheet) and amortize or depreciate or spread out those costs over the expected benefit of those enhancements.
This would smooth out earnings on the income statement and better align the repair costs with the revenue they generated.
Capitalization Example
Say you had a $10,000 repair that you expected to provide benefit over 2 years.
If you don’t capitalize it, you would expense it on your profit and loss statement when you incur the cost. This lowers your net income and taxable income by $10,000 in year 1.
If you do capitalize, your net income would be $10,000 higher and those costs would be added to the asset value on your balance sheet. You would then record your depreciation expense of $5,000 per year, so income would only decrease by $5,000 in year 1 and $5,000 in year 2.
When does it apply?
Like we said, repairs happen all the time. They are part of doing business. Therefore, when dealing with property, plant and equipment, and real estate, it applies all the time.
How do you treat these transactions consistently?
Best practice is to create an accounting policy to guide your company’s transactions! The policy outlines a threshold for capitalization.
If the expense is under the threshold, expense it on your profit and loss.
If it is above the threshold, capitalize on your balance sheet.
What do you expense vs capitalize?
It depends!
US GAAP does not permit or explicitly state an amount to expense or capitalize. In other words, there is no bright line capitalization threshold.
It depends on what is material to your company.
What is material to your company?
If your company generates $100,000 in revenue per year and you expense every improvement below $20,000, then this seems unreasonable.
In other words, you will likely rarely have an expense over $20,000 and therefore everything would go through your profit and loss as expense.
GAAP and tax are different reporting standards, but the IRS does provide a tangible property regulation.
Within it, Notice 2015-82 specifies some thresholds that could help you set an expectation for your company.
$2,500 for companies WITHOUT applicable financial statements (i.e. unaudited financials) and $5,000 for those WITH applicable financial statements.
This is not a ceiling of what can become your policy threshold, but a starting place.
Best practice is to create an accounting policy to guide your company’s transactions!
How to capitalize costs and place them in service?
It depends!
Need to turn to the guidance to draft your policy.
For guidance on property, plant and equipment, refer to ASC 360.
Costs are evaluated based on the stage of the project.
For example, preliminary costs (inspections, site selection, consulting fees, etc.) can be elected to be expensed under ASC 720-17.
Pre acquisition costs should for the most part be capitalized.
Construction costs should be capitalized and can elect to expense normal SG&A costs as incurred.
Real estate has its own beast of guidance in ASC 970.
Per ASC 970-360-30-1 (a), we allocate the capitalized cost based on the relative fair value before construction.
A good way to determine fair value before construction would be to use the county assessor office parcel information to determine land vs. property value. You can apply this ratio to your costs to break out land vs. property and determine what to depreciate.
How to record depreciation expense on capitalized costs?
If the capitalized costs are related to revenue generating activities (i.e. rental staging, brochures, etc) then these costs are depreciated over the lease term.
If capitalized costs are not tied to a revenue generating activity, then depreciate them over the expected benefit period.
Partial property ready for service and partial under construction.
Creating an asset capitalization policy
The best way to approach asset capitalization for your company is to create a policy to guide your transactions.
This helps you support your position should you ever get audited and helps you apply a consistent method of accounting to your financials.
Since there is no definitive guidance on the amounts, you can change the capitalization amount as materiality changes.
You would not go back and make this change to prior periods, only to future periods.
It is not considered a policy change and does not require any financial statement changes or disclosures.