Question

Redline Publishers, Inc. produces various manuals ranging from computer software instructional booklets to manuals explaining the installation and use of large pieces of industrial equipment. At the end of 2021, the company’s balance sheet reported total assets of $62 million and total liabilities of $40 million. The income statement for 2021 reported net income of $1.1 million, which represents an approximate 3% increase from the prior year. 

The company’s effective income tax rate is 30%. Near the end of 2021, a variety of expenditures were made to overhaul the company’s manufacturing equipment. None of these expenditures exceeded $750, the materiality threshold the company has set for the capitalization of any such expenditure. Even though the overhauls extended the service life of the equipment, the expenditures were expensed, not capitalized. 

John Henderson, the company’s controller, is worried about the treatment of the overhaul expenditures. Even though no individual expenditure exceeded the $750 materiality threshold, total expenditures were $70,000. 

 

Required: 

Should the overhaul expenditures be capitalized or expensed?

 

 

Answer 1

Expenditure subsequent to purchase:

Long lived assets when purchased require repair, maintenance, addition, improvement or rearrangement over the period of time, depending upon the type of requirement.

 

The question lies whether such expenditure incurred should be capitalized i.e increase the cost of assets and book depreciation accordingly or should be expensed into profit & loss a/c.

 

Basically, capitalization is done when the expenditure incurred is expected to reap future economic benefit, however it should be expensed if it maintains the equal level of benefit as that asset was producing when no such expenditure was incurred.

 

Conditions to Capitalize or Expense:

A subsequent expenditure should be capitalized if it is anticipated to give future economic benefits.

The future economic benefits can be in three forms-

 

1) Extended or exceeded useful life of the asset,

2) Increased operating efficiency in terms of less operating cost and increased production volume.

3) Increased or better quality of the products.

 

If any of the above ways are being fulfilled then subsequent expenditure should be capitalized in the year of incurrence, otherwise it should be expensed out.

 

Materiality as a factor for Capitalization:

Materiality plays an important role in deciding whether such expenditure should be capitalized or not.

 

Some companies set a threshold of materiality limit of the expenditure as a determining factor irrespective of whether there is increase in future economic benefits or not.

 

Any amount below the specified limit is expensed out, so the judgement is required to decide the above-mentioned limit.

 

Analysis & Conclusion:

In the given question it is seen that the overhaul expenditure was incurred of $70000 which is exceeding the threshold limit of $750.

 

This subsequent expenditure is increasing the service life of the equipment even though the individual expenditure is not increasing threshold limit and has been expensed.

 

As per the capitalization condition mentioned above, the company is expected to reap future economic benefits in terms of increased useful life of the asset.

 

Further the total overhaul expenditure exceeds the materiality limit.

 

Hence it is advised to capitalize the expenditure.

Expenditure subsequent to purchase:

Long lived assets when purchased require repair, maintenance, addition, improvement or rearrangement over the period of time, depending upon the type of requirement.