To Capitalize or Not to Capitalize

In the previous blog, “What are Fixed Assets?,” McKonly & Asbury’s Entrepreneurial Accounting Solutions (EAS) team explained the basics of capitalization and fixed assets. The article noted that large repairs can extend the useful life of assets already placed into service, making it necessary to capitalize the repair. So, how does a company determine whether an expense is a repair or needs to be capitalized? Continue reading to learn what differentiates an expensed repair from a capitalized asset.

Not all repairs to fixed assets are created equal. Sometimes, repairs extend the useful life of an asset, which changes how the repair is treated on financial statements. When a repair does not extend the useful life of an asset, it is expensed on the Profit & Loss statement and is a one-time event. However, a repair that does extend the useful life of an asset is recorded on the Balance Sheet for the next several years and is expensed over time. Therefore, it is important to review repairs that may provide future economic benefits for capitalization.

What Kinds of Repairs Extend the Useful Life of Assets?

When a repair goes beyond routine maintenance and improves the asset’s longevity, capacity, or structural integrity, the repairs will result in capitalization. Some common examples include replacing a roof on a building, rebuilding the engine of a vehicle or machine, replacing major HVAC components, replacing plumbing or electrical wiring throughout a building, or replacing worn-out parts of equipment that are critical to functionality. It is recommended to regularly review expenses to determine if any repairs extend the usefulness of a piece of equipment, vehicle, or building.

As an example, a company purchased a new HVAC unit five years ago. During its preventative maintenance, the contractor discovered that the filter and heat pump needed to be replaced. The filter is a part of the HVAC unit that is changed on a regular basis. While a new filter serves an important purpose, it is regular maintenance and does not improve the life of the HVAC. On the other hand, the heat pump is a major component of the HVAC unit. Without the heat pump, heat would not be transferred in or out of the building, and the HVAC unit would not work properly. The cost of replacing the heat pump would qualify as a capitalizable fixed asset. The filter replacement would be expensed.

What Happens When a Repair Is Capitalized?

Capitalization delays the full recognition of the expense by spreading it out over the life of the asset through depreciation. A benefit of capitalizing an asset is that it increases the value of the assets on the balance sheet until fully depreciated, which increases the value of the business. In addition, by spreading the cost of the expense over several years, the expense matches the usefulness of the item as it is used. For example, an HVAC repair extends the life of the unit by five years. By recording it over five years, the cost is recorded each year of usefulness.

Is There a Safe Harbor Dollar Threshold for Capitalizing Repairs as Assets?

Not all repairs that extend the useful life of an asset need to be capitalized. The Internal Revenue Service (IRS) has implemented a $2,500 de minimis election IRS Notice 2015-82, which is made on the tax return each year. This helps to reduce the administrative burden on companies.

The same dollar threshold can be used for financial purposes as well. While the election can be made on the tax return, it’s also important to have a signed capitalization policy on file for other reporting purposes. In addition, companies and nonprofits with high revenue may want to determine a higher threshold. It becomes especially important to have this policy in writing if electing higher dollar amounts. Implementing a capitalization policy with a dollar threshold can help a company with the decision-making process of deciding when a repair is expensed or capitalized.

Final Thoughts

Repairing fixed assets is more complicated than it may first appear. Having a signed capitalization policy on file and evaluating each repair over that threshold will help a company ensure that it is properly recording its expenses on the financial statements and for tax reporting purposes. A tax advisor or accountant can help a business create a capitalization policy, review its expenses and assets, and ensure that the correct depreciation methods are selected.

For specific questions, assistance, or additional information, please do not hesitate to contact a member of our EAS team.

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