After acquisition of asset and once its brought to condition where it can achieve its intended purpose, company may incur additional costs. This opens a new chapter on how such subsequent expenditures be treated.
Whether it should be added as cost of the asset or treated as an expense in income statement. To clarify this confusion we need to understand different types of expenditures and few basic principles to separate revenue expenditures from capital expenditures.
If subsequent expenditures are categorized then types include:
- Repairs, maintenance
- Additions, expansion
- Replacement, overhaul, upgradation
- Relocation
1 Repairs, maintenance
Repairs are such costs that are incurred to keep the asset operational at optimum condition. Such costs neither extend the useful life of the asset nor helps in increasing efficiency or effectiveness of the asset. However, if repairs are not done then certainly the efficiency and effectiveness of asset will suffer and falls below the optimum level.
For example, personal computers require regular cleaning so that they can operate at optimum temperature. Dust and other residue if not cleaned will cause processors to overheat and malfunction.
Similarly if engine oil is not changed after certain miles it will affect the engine’s life and overall function. If engine can run for 5 years then its possible only with necessary repairs and maintenance being carried out on timely basis otherwise it will fail in less than 5 years.
2 Additions or expansions
If expenditure has resulted in the increase in capacity, output or its potential to reap benefits then such expenditures will be capitalized and added as part of cost of the asset.
For example expansion of warehouse, building a new room in head office building, addition of boiler to current processor to give more output per hour.
3 Overhaul or upgradation
Instead of adding something to existing to asset, entity may simply replace the current asset or component of asset replacing the old one to increase the quantity or quality of benefits asset can render. Therefore, such costs are added in cost of the asset.
If get deeper int he meanings overhauling and upgrading an asset are two different things.
In overhauling the asset, we simply replace older parts because they are not working at optimum level or their useful life has ended. So we are simply substituting same asset or component of asset like the old one. For example, engine of car got seized and thus replaced with similar engine.
On the other hand, upgrading an asset involves replacing an asset or component of asset with a better asset that renders better quantity or quality of benefits from asset. For example an older engine that was giving 11 kilometers per liter is replaced with a newer engine that gives 21 kilometers of mileage.
For example, a car that is supposed to give 11 kilometers per liter of fuel will not operate at such level if engine is not tuned on time and plugs are not replaced. Therefore we have to conduct such repairs to keep giving the optimum mileage.
On the other hand of engine is blown, meaning it can no longer work as it has expired. Replacing the blown engine with similar one so that it can now work for extended period is overhaul. And upgradation is simply replacing the old engine with the one that gives 21 kilometer mileage for every liter of fuel consumed.
4 Relocation
Relocation costs are incurred to move an asset from one place to another and may involve dismantling and re-installation costs. Accounting treatment of relocation costs can become tricky as it depends on the question if relocation will render future benefits.
As a general principle once the asset is in a state of its intended use then any cost afterwards will be treated as expense and not added to carrying amount of the asset. For example, a furnace has been installed and now ready to use but later it is discovered that the platform is not strong enough and may collapse therefore has to be dismantled and to be reinstalled again in a different factory. Then such dismantling and installation cost is not added in the cost of furnace.
If relocation of asset will render additional benefits then such costs can be capitalized. For example entity has a machine installed in a city where demand of its product has reduced significantly. It is expected that if machine is moved to another city, where product is still in high demand, will help increase revenue. In such case relocation costs may be added in the carrying amount of asset.
However, International Accounting Standard (IAS) 16 has clearly stated that relocation related costs are not to be capitalized.
IAS 16 para 20 uses even more appropriate word i.e. costs incurred on redeploying asset. According to IAS 16 para 20:
Recognition of costs in the carrying amount of an item of property, plant and equipment ceases when the item is in the location and condition necessary for it to be capable of operating in the manner intended by management.Therefore, costs incurred in using or redeploying an item (asset) are not included in the carrying amount of that item.
Therefore, it is clear that once the non-current asset is brought into intended condition then relocation expenses, even if they are material, they are not included in the cost of the asset and should be treated as an expense in profit and loss.
IAS 16 even explains further that not just non-current asset’s relocation costs are treated as expense but even the expenditure on relocating or reorganizing part or all of an entity’s operation are also not form part of the carrying amount of the asset.
Similarly in IAS 38 Intangible Assets para 68(d) it is stated that expenditure on relocating or reorganising part or all of an entity are treated as expense in the period they are incurred.