8. Capital expenditures are extended or acquired assets.—Most of the errors in principle that occur in practical work show a lack of desire to discriminate strictly between capital and revenue items. One needs to bear in mind in this connection that all expenditures recorded as capital expenditures must be represented by actual assets. Nothing remains to represent ex penditures that have been incurred upon revenue ac count. Has the particular expenditure, in any indi vidual case, been incurred for the sake of improving the earning capacity of the enterprise? If so, it is a charge against capital and should be classed as one. If, however, the result of the expenditure has been merely to put the earning capacity of the undertaking on the same footing as before a decline—such decline being due to ordinary wear and tear—then it must be charged against revenue. Not mere renewals but only the extension or acquisition of new assets can be recorded as capital expenditures. If an asset for which an expenditure was made exists at the end of the current period as an asset, such expenditure should be charged to capital. On the other hand, if the asset is consumed during the current earning period, it must then be charged against the revenue of that period.
We frequently have examples of expenditures that may or may not result in a direct increase in the earn ings of an organization; thus where a railway com pany tears down an old station and replaces it with a larger, more commodious and more modern structure, considerable doubt exists as to whether such expendi: ture could be properly capitalized. It is granted that the earnings will not increase; nevertheless the exist ing structure was inadequate, and undoubtedly the building of the new station will result in a continuance of public favor and patronage. In such a case it is considered proper to capitalize the new structure and displace the cost of the old station from the asset ac counts.
9. Accounting practice in the case of replacements. —From the definition which has been given for re placement, it is evident that the term conveys the idea that one article is substituted for another of the same or greater value or capacity as distinguished from a renewal which renews some existing article by manuJ facture or extensive repair. Some accountants, how ever, claim that inasmuch as variations in cost are to be expected, therefore only bona fide investments should be capitalized. To illustrate: If assets which originally cost $200,000 were to cost in renewals $250, 000, the whole cost of such renewals would be a revenue charge. If, however, the assets which ordinarily cost $200,000 were replaced by assets of a higher revenue earning capacity, due to the superior quality of the materials used for the making of such assets, the method of apportioning would be as follows : ascertain what the exact cost of replacing the existing asset would have been and then charge only that sum to revenue and capitalize the excess.
Many accountants follow the policy of considering the "last cost" as a capital charge. If assets which originally cost $10,000 are replaced at a cost of $12,000, the excess is charged against capital. In other words, they claim that the last cost is the only correct basis because each concern will replace its plant at the least possible expense to itself.
10. Objection to capitalization on basis of last cost. —The latter plan appeals to the writer as a most de sirable and fair method to be followed in all cases, because under this practice the plant always appears in the accounts at the last cost, that is, the cost of the plant as it stands at the present time. Therefore, the reconstruction cost would be charged to capital and the cost of the construction or equipment formerly on the books would be displaced.
The principle is of importance in the case of public utilities where the question is involved of determining a rate which is fair to the consumer and yet will yield to the utility a reasonable rate of return on its invest ment. It is urged that it is only fair to the utility that the investment in plant shall appear at the present cost of the plant and not at that of some earlier date when perhaps material and labor charges were much less. Opinions differ in this matter but it is worthy of note that most of the commissions charged with the duty of regulating public utility companies favor a provision for the payment of extraordinary replace ments out of earnings.
In the volume on "Corporation Finance," the reader has seen that prior to the declaration of dividends, the board of directors of a conservatively managed corporation will set aside a reserve for the replace ments of an extraordinary nature that are not fairly chargeable against the revenue of the year in which they may be made. Thus, a railroad which was by law compelled to abolish grade crossings on its right of way, might find it more economical to build a new right of way instead of attempting to abolish the present grade crossings. Under the ruling of some of the regulatory commissions, the new right of way would be a proper charge to capital and the cost of, the old right of way should be credited to the prop erty account and charged to an abandoned property account to be written away over a series of years. Pending its final elimination from the balance sheet it would be carried as a deferred charge to future operations. If a reserve for such contingencies had been provided, the cost of the abandoned property would be charged to that account. If the ledger did not disclose the cost of the abandoned property, the estimated replacement cost would be the amount used in the credit to property account and the charge would be made to abandoned property account.