Accounting theory and practice, Volume 2 (of 3)

by Roy B. Kester

Treatment of Renewal of Parts

In the maintenance of a property in efficient condition, repairs and renewals are constantly taking place. When for an old part or plant unit a new one is substituted, the question of betterment immediately arises. If an old machine with book value of $500 is replaced by one costing $750, the excess of $250 is classed as a betterment and is properly a charge to capital. A renewal of machine parts cannot be handled so easily. The parts of a machine are subject to diminution in value due to wear, tear, and obsolescence, along with the machine as a whole. The machine was purchased for a lump sum. What portion of the cost is applicable to each individual part is difficult to determine and must usually rest on estimate or guess. Similarly, the book value, i.e., the present depreciated value of a part, is not accurately known. Accordingly, the amount of betterment, if any, in the replacing of an old part by a new part is difficult to determine. It is here that working rules must be adopted for each concern.

Thus, it has been suggested that only when the renewal involves an expenditure of $5 or more should there be any attempt to determine the amount of betterment, every expenditure under $5 to be charged to expense. In an establishment of any size this is altogether too small an amount. The Chicago Traction System through its board of supervising engineers has established $200 as the minimum charge to capital or renewals. All transactions involving even a true betterment, if the amount is less than $200, are to be recorded as maintenance charges. As a means of simplifying the accounting, a working rule, with a minimum capital charge adapted to the conditions of each concern, serves a practical and useful purpose.

Treatment of Cost-Cutting Changes

Other kinds of expenditures which cause trouble as to their proper place of record are those incurred for the purpose of facilitating the handling of the work. They may result in an increase of capacity to earn revenue through a speeding up of production, or the result may be simply a lessening of the expense of turning out the various units of product. A test frequently applied in such cases is that of increased earning capacity. It is argued that even though nothing tangible which did not exist before has been added to the plant, there has been a rearrangement of the factors of production with a resulting co-ordination of effort, and this has increased the capacity of the plant, thus making it more valuable. Inasmuch as this value is measured by earnings, the cost incurred in securing the increase is a very proper and legitimate charge to capital. Against this argument, it may be said that plant or structural changes are always made to improve operation. To make increased earning capacity the sole test is virtually to capitalize all expenditures of this kind—a policy which would soon lead to an unconscionable inflation of assets. Only by a policy of very liberal depreciation can such values if capitalized be kept within reasonable bounds. The impropriety of charging such expenditures to the current profit and loss account is generally acknowledged.

The best practice is to handle items of this kind as deferred charges under suitable descriptive caption, instead of as charges direct to the asset account where the nature of the items is soon lost from view and the need of a high depreciation rate to write them off is soon forgotten. Thus, a rearrangement of the machinery in a plant may bring about a more economical routing of the product, or the introduction of a new machine may entail an entirely changed disposition of existing machines—all for the purpose of, and actually accomplishing, a saving in costs. Rather than a charge of the costs incurred to the asset account Machinery, a setting of them up under the title “Rearrangement Costs of Machinery,” or other similar title, shows their exact status and makes possible an intelligent writing down of them periodically in accordance with the estimated life or continuance of the savings effected. Practically this amounts to treating the costs as capital expenditures if the saving effected is judged applicable to more than the current period. The chief difference is that booking such items as deferred charges calls for specific attention to the need of a speedy writing off.

Asset Subject to Depreciation a Deferred Charge to Operations

In this connection it may be pointed out that the cost of all assets subject to depreciation may well be looked upon as deferred charges to operation, some portion of that cost being charged off at the close of each fiscal period. “So we see that capital expenditures, as distinguished from expenses, are at last an arbitrary conception. It begins with the idea that certain expenditures have an efficiency which reaches over many earning periods extending indefinitely into the future. But nothing physical would last so long, and its earning power might have even less permanence. To meet this condition we arbitrarily designate certain expenditures whose effect indefinitely outlasts the immediate earning period as ‘capital,’ and then in the same arbitrary way, through all subsequent vicissitudes, we hold them to their first value by maintenance, renewal, and depreciation charges which are borne by other expenses.”[13]

Authorization for Booking Capital Expenditures

As regards a suitable method for handling transactions which involve a separation into capital and revenue charges or a determination of the status of the transaction as between capital and revenue, proper authority should be secured for making the expenditure. Where possible, before its incurrence, authorization as to its proper booking should be given, even to the amounts where feasible, and this order becomes thus the voucher supporting the entries on the books.