Repairing business assets usually makes for simple accounting. You spend $50 repairing your copier; you record a $50 repair expense. Repairs and upgrades big enough to qualify as capital improvements are a different story. Under Generally Accepted Accounting Principles (GAAP), you treat these improvements as added assets and depreciate them over time.
TL;DR (Too Long; Didn't Read)
Under GAAP, you record repairs and maintenance as an expense. The cost of significant improvements, such as a new engine in a truck or installing a more efficient HVAC, must be depreciated over time.
Fixed Assets and Useful Life
Knowing the difference in GAAP between making repairs to business property and capitalizing building improvements, for example, requires understanding fixed assets and their useful life.
Fixed assets include vehicles, computers, furniture, buildings, land and machinery, among other items. To qualify as fixed, an asset has to have a useful life greater than one year and be worth more than the company's capitalization or cap limit. By treating purchases below the cap limit as expenses, businesses can skip the record keeping required for depreciating capital assets.
Useful life is how long your accounting treats an asset as having value. If an asset's useful life is five years, for example, you depreciate 20% of the asset's cost every year. Useful life is an accounting approach, not a requirement that you junk the asset and replace it when the life span expires.
Repair vs. Capital Improvement in GAAP
When do repairs to fixed assets become capital improvements? Under GAAP, they have to accomplish one of three things:
- Extend the asset's useful life
- Enhance the overall value
- Adapt the asset so it can be used in a new way
Everything else is an expense.
Take roofs as an example. Patching holes and cleaning gutters count as routine repairs and maintenance expenses. By contrast, putting on a new roof extends the building's life span. Putting on new, better-quality shingles may enhance the property's value.
On a company vehicle, replacing tires or putting in a new battery counts as standard maintenance. Replacing the engine is a capital improvement, as it extends the life of the car. Adding a hydraulic lift to a truck qualifies as increasing its overall value.
Expense and Improvement Bookkeeping
Under GAAP, when your company repairs a fixed asset, you record it as an expense in your accounting journals. For example, suppose you pay $300 to fix a brake problem in your company truck. You report $300 of spending in cash or accounts payable and enter $300 in the vehicle maintenance account.
Now, suppose that instead of a $300 repair, you spend $4,000 installing a new engine, which is over the $2,500 cap limit. You record the $4,000 bill in cash or accounts payable and add $4,000 to the account for vehicle assets. You make the same sort of journal entries for building improvements or major upgrades to factory equipment.
Improvements to Land
The accounting treatment for building improvements works like other capital improvements. If you're making improvements to land, however, it gets more complicated. Land is unique among fixed assets because it doesn't depreciate in value unless you're doing something like mining it for minerals.
Land improvements can include demolishing a building, digging a drainage ditch, fencing in the property or landscaping. Even though these changes last longer than a year, they aren't all capital improvements under GAAP:
- Razing a building doesn't count as an improvement and isn't depreciated. Treat it as part of the cost of the land.
- Landscaping is always an expense.
- If you can't set a useful life on an improvement, you expense it rather than capitalize it.
- If the improvement has a useful life, you report it as a capital asset, entering it in the accounts as land improvement. You depreciate it like other capital improvements.
Depreciating Capital Improvements
Under GAAP, fixed assets above the cap limit aren't written off as an expense. Instead, you claim them over time by depreciating them over the useful life of the improvement. For example, if you spend $6,000 on new fencing, and it has a 10-year life span, you depreciate $600 a year or $50 a month.
Under GAAP, you record this in your accounting as depreciation expense and as accumulated depreciation. It doesn't affect your cash flow because you don't spend money on it, but you do subtract it from your revenues on the income statement.
Accumulated depreciation becomes a negative or "contra" asset on your balance sheet. Anyone reading your financial statement subtracts the accumulated depreciation from the relevant assets to get their book value.
Setting the Cap Limit
If you make an upgrade that's less than your company's cap limit, then it doesn't matter whether it meets one of the three tests for capital improvements. You expense it instead of depreciating it. For example, suppose you make $1,000 in improvements to your computer, but the company cap limit is $2,500: Your improvements are an expense.
GAAP gives you the flexibility to set your cap limit. You're free to set it low, high or in between. There are several factors to consider:
- When the cap limit is low, you expense less and depreciate more. Immediate profits in your accounts are larger as you don't have to subtract the improvement expense, but you have to claim more depreciation down the road.
- A high cap limit means fewer assets to depreciate, which saves a lot of accounting work.
- A high cap limit also means treating more big-ticket items, both improvements and purchases, as expenses. That's going to make your month-to-month profits swing wildly when you subtract those expenses from your income.
- A low limit gives your business ownership of more fixed assets. That could increase local property taxes. An extremely high limit solves that problem, but it might trigger a tax audit.
Case by Case
When debating repair vs. capital improvement in GAAP, it's important to judge each case on its own merits. Sometimes it's obvious: Replacing a frayed wire, repairing a roof leak, or having your company car's oil changed are expenses.
Other times, though, it can get more complicated. You might hire a roofer to repair a leak, then discover that half the roof needs to be upgraded. The original project was just a repair expense, but by the time the roofer's done, you have a capital improvement.
Must I Use GAAP?
GAAP's rules, as the name says, are generally accepted principles. They're not universally accepted requirements that every business must follow.
Corporations with publicly traded stock have to follow GAAP, and all their financial statements must be GAAP-conforming. Other companies, such as privately held corporations, partnerships and sole proprietorships, may use GAAP or not, as they choose. Adopting GAAP has both pros and cons.
- If you're looking for loans or outside investors, they'll want to see GAAP-style accounting. They're familiar with it, so it's easier to evaluate your business. It also makes it easier to compare your company's finances with others in the same industry.
- If you want to compare your company with the competition, it's easier if you both use GAAP accounting.
- GAAP uses accrual accounting: You report income and expenses when they're earned, not when money changes hands. If your company runs on a cash basis, GAAP isn't compatible.
- GAAP accounting is different from tax accounting. Companies that use GAAP also need a second set of accounts as the basis of their tax returns. Some small businesses prefer to use tax accounting alone; keeping a GAAP set of books as well isn't worth it to them.
Capital Improvements and Taxes
Under GAAP, whether you choose depreciation or expense for a particular improvement affects your financial statements, but that's all it does. Whether you write off a $2,000 building repair or depreciate it over 10 years affects the profits and your assets shown on your statements, but it doesn't let you pay the contractor's bill any later.
Taxes are a different kettle of fish. Whatever you deduct as an expense gives you an immediate reduction in your taxable income. Items you depreciate give you a recurring tax deduction over several years. You might want to expense a capital improvement upfront as an immediate deduction, but it's not always possible.
If you depreciate a capitalized improvement under GAAP accounting, you do it straight line, depreciating the same amount each year until the asset's useful life runs out. Under IRS rules, you have several methods for claiming depreciation as a business deduction:
- Section 179
- Bonus depreciation
- Regular depreciation
- Accelerated depreciation
Section 179 allows you to claim the entire cost of a qualifying capital improvement as an expense for the year you made the purchase. You can claim up to $1 million in improvements and purchases, although there are some limits on the deduction that lowers that ceiling.
The IRS exempts some building improvements from Section 179. If you're installing an elevator, enlarging the building, or renovating the structural framework, Section 179 is not an option. Nor does Section 179 allow you to write off exterior improvements, only those on the building interior.
Bonus depreciation gets you the same benefits as Section 179 by a slightly different route. Rather than expense the capital purchase or improvement, you can take a large chunk of depreciation upfront. In late 2019, you can deduct 100% of qualifying capital spending, but that percentage will drop after 2023.
There are a number of restrictions on taking bonus depreciation. For example, if you buy a fixed asset from a related party, such as a business subsidiary, bonus depreciation is off the table.
Tax Depreciation of Improvements
If you can't or choose not to take Section 179, you have to write off improvements by depreciation. The accelerated depreciation schedule allows you to claim a larger deduction in the early years, as opposed to regular straight-line depreciation, but you end up with the same amount written off either way. A $20,000 new roof, for example, can't be depreciated for more than $20,000, no matter which method you use.
Tax laws and rules have their own standards for when something counts as a capital improvement:
- If you're repairing damage, even if it's an entire roof or floor, that's still a repair expense.
- If you replace a roof with more advanced materials to improve the worth or life of the building, that's a capital improvement. If you used superior materials because the old ones aren't available or allowed, that's a repair.
- If you're enlarging the building, related repairs and improvements have to be capitalized.
If you end up going with standard, straight-line depreciation, you may have to write your costs off over anywhere from 15 to 30 years, depending on the useful life. It's up to you and your accountants whether you'd rather take a larger write-off upfront or smaller amounts over time. As tax laws are in constant flux, the merits of either strategy may change at any time, so stay informed.
- Accounting Tools: Capital Improvement Definition
- First Service: Maintenance and Repairs vs. Capital Improvements – What’s the Difference?
- Accounting Tools: Capitalization Limit
- Accounting Tools: Fixed Asset
- Accounting Tools: Useful Life
- Milam, Knecht & Warner, LLP: Repairs vs. Capital Improvements
- Accounting Coach: Repairs and Maintenance Expense Definition
- BKPR: Accounting Entries for the Purchase of a Vehicle
- Double Entry Bookkeeping: Capital Improvements After Asset Acquisition
- Accounting Coach: What Is Accumulated Depreciation
- Accounting Tools: The Correct Capitalization Limit
- Marks Paneth: GAAP vs. Tax-Basis Reporting
- IRS: New Rules and Limitations for Depreciation and Expensing Under the Tax Cuts and Jobs Act
- KBKG: KBKG Tax Insight: Guide to Expensing Roofing Costs
- Canopy: 2019 Guide to Section 179 and Bonus Depreciation