capitalization - Capitalization , Amortization, and...

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Capitalization , Amortization, and Depreciation Introduction In general, expenses are deductible if allowed by a specific code section. Capital expenditures, in contrast, are not deductible; instead, they must be added to the basis of an asset. From there, they may – or may not – result in future depreciation or amortization, depending on the type of asset. For example, the cost of land must be capitalized and is never subject to depreciation or amortization recovery. In contrast, five years worth of pre-paid insurance must also be capitalized; however, it may then be amortized over the five-year life. These very simple rules are subject to some controversy and require much refinement. The difference between an expense and a capital expenditure is sometimes obvious. For example, the replacement cost of a single shingle blown off a roof by a hurricane is clearly an expense – and thus not subject to capitalization - for two reasons. First it is minor – and thus not worth the process of capitalization and depreciation. Even though the shingle itself may actually last many years, depending on the remaining life of the roof, the minor cost is not worth the accounting trouble. Second, its replacement does little to change or extend the life of the main asset – the roof. Hence it is just a short-term, minor repair and gives rise to the allowance of a deduction under section 162 as an ordinary and necessary business expense (assuming, of course, the roof was on a building used for a trade or business). For accounting purposes, we would debit an expense account – repairs – and credit a payable or cash account to reflect the payment or the creation of a liability. At the other extreme, an entire new roof will last some twenty years and its costs must surely be spread over that time frame. The process of doing so is called capitalization of the expenditure and depreciation of the asset. Technically, for accounting purposes, we would debit an asset account for the cost and credit either a payable or cash account to reflect the payment or creation of a liability. The asset account may be a separate asset - called new roof – or it may result in an adjustment to the basis of the building. As illustrated below, however, many fact patterns do not so clearly involve a simple repair or an obviously new long-term asset. They can be very close to the line delineating repairs versus capital improvements. As we will see, that line can be both fuzzy and a moving target. Courts have mostly resolved it using a facts and circumstances method of analysis. Other issues of capitalization involve the various accounting methods. As a general rule cash method taxpayers may deduct expenses when paid. As a general rule, accrual method taxpayers may deduct expenses at the later of incurrence under the “all events” test and economic performance pursuant to section 461(h). Each of these general rules, however, is subject to regulations under section 461 and 263 plus several important appellate decisions. Some of these authorities have been, at least historically, controversial.
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capitalization - Capitalization , Amortization, and...

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