Bookkeeping that records every payment for property repairs as an expense is just so much fiction. Cash outflow isn’t always found on the business income statement – also known as the profit and loss statement. In fact, it’s the balance sheet that reveals whether money was directed to decreasing debt or increasing assets.
Expenditures for so-called capital goods appear on the balance sheet as fixed assets. These items – such as equipment and buildings – are different from ordinary operating expenses on the income statement.
But “capital goods” can also include repairs to existing fixed assets. The cost for these expenditures is depreciated over time rather than immediately appearing as an expense on the profit and loss statement.
Small-business operators are frequently faced with deciding whether a cost is a repair expense or a depreciable capital expenditure. And this can prove a sizable burden.
Improvements to existing fixed assets constitute a new capital expenditure when the cost is sufficiently high for capitalizing and the improvements extend the useful life or functionality of the fixed asset. These are distinguished from repair expenses, which constitute minor alterations. Capital improvements are generally structural – such as a new roof for a building. More cosmetic costs – like painting – are expensed as repairs.
Distinguishing between a repair and a capital improvement is complex. Tax authorities have released some general guidelines to help. A capital improvement is an expenditure for the “betterment,” “adaptation,” or “restoration” (B.A.R.) of the property. Determining whether any of these conditions applies requires comparing the condition of the property when it was purchased – or when the last work on it was performed – to its condition after the new expenditures.
“Betterment” ameliorates a deficient condition in property and adds to a property’s capacity, size, or quality. “Adaptation” changes a property to a new use that’s different from the original, and “restoration” returns property to its efficient operating condition. “Restoration” also applies to any major component of a property that contributes to the property’s substantive function, which can make identifying a capital improvement tricky. It means, for example, that replacing the motor necessary for a machine to run properly is a capital expenditure, even though the entire machine is not being replaced. Work performed on smaller assets – such as machinery – is commonly a capital expenditure. A component critical to the usefulness of equipment is very likely a capital improvement when replaced – unless the cost is minimal.
Large properties – like buildings – are more likely to incur repair expenses. Tax rules require dividing a building into multiple property units; the entire building is not a singular property, but rather each system in the building is considered separately. So replacing the air conditioning compressor might be a depreciable capital improvement, since the ventilation system is viewed as a distinct property unit.
Uncovering whether expenditures are repairs or capital improvements isn’t easy. The best way is to consult a tax expert when these costs are incurred so that purchases are correctly recorded.