Repairs on Second-Hand Plant
In one situation repair charges which are ordinarily an expense must be capitalized. Where a company takes over a plant which is badly run down and out of repair, the expenditures necessary to bring it to a state of efficient operation are capital expenditures. Such a plant resembles a partially completed plant, and the purchase price is supposed to take that fact into consideration. It is expected that additional capital will have to be sunk to rehabilitate the property and put it in a condition of repair necessary to earn revenue. Accordingly the expenditures necessary to do this are rightly treated as capital charges.
Construction Costs
A final consideration in the distinction between capital and revenue expenditures has to do with certain costs incurred during the period of original construction. We may cover the situation by a general statement to the effect that all costs necessary to produce a complete plant in condition ready to earn revenue are proper charges against capital. Thus, interest on moneys borrowed for construction purposes is a proper charge to capital, and in England it has been held that dividends in the form of interest are allowable to shareholders during the construction period. Also, such items as engineering and superintendence, law expenditures, injuries, taxes, etc., both preliminary to the construction period and during it, are to be capitalized. On the other hand, profits on own construction work are never to be counted as costs. To do so reveals a misunderstanding of the difference between a profit and a saving. The matter is discussed more at length elsewhere.
As to whether any portion of the overhead expenses has a rightful place among the assets must be determined by the conditions in each case. In original construction work, before operations begin, all overhead charges constitute a part of the cost of the assets. For betterment work and additions carried on concurrently with operation, the case is not so clear. A safe principle is to treat as capital charges all increases in overhead above what would normally have been incurred for operation only. To free operation of any portion of the regular overhead just because betterments are in progress is not recognized as a sound or conservative policy.
Distinction between Capital and Revenue Expenditures often Based on Opinion
Thus it is seen that many phases of the problem of capital and revenue expenditures are extremely difficult of determination and in their final analysis rest on estimates and opinions rather than definitely established facts. Too often it is feared that decision in matters of this kind is “influenced by unsuspected individual caprice and by considerations of the financial convenience of the moment”; for the allocation of such items may sometimes represent the margin between a profit or a loss for the current period. As is said to be true of geometry, so here there is no royal highway to the solution of these problems.
Main Groups of Asset Items
If, therefore, it can be determined what items are to be included in the balance sheet and the proper basis for their valuation can be established, the problem as to its content is well on the way to solution. Having discussed the elements and factors entering into a determination of cost value, we are in a position to state the principles of valuation applicable to the main groups of items as set up in the balance sheet. These may be listed, for the purpose of this generalization, under three heads, viz.: (1) current assets, (2) deferred charges to operation, and (3) fixed assets.
1. For the current assets, the principle of valuation may be stated as valuation on the basis of cost or market, whichever is the lower. Since speedy realization of the current assets by conversion into cash for its equivalent is the aim and expectation of every business—for on such conversion depends the ability to meet the current liabilities and so have working capital available for another cycle of purchase and sale (another turnover)—it would seem that the realization price as given by the market should govern. In the interest of conservatism and as producing certain other desirable results which will be brought out as each asset is examined in detail, cost price, if lower than market, is deemed the desirable basis for the valuation of this group. By way of explanation, it should be said that working capital as used here is the difference between current assets and current liabilities and so represents the portion free to be put to the further pursuit of business.