How to Improve and Replace PP&E
Improving is the process of substituting a better asset for the one that’s already in place. Replacing means the company swaps out the old asset for another one that’s similar in nature.
If the improvement or replacement increases the future service potential of the asset, capitalize the cost. You can handle this in three ways: using the substitution approach, using the new cost, or using the accumulated depreciation account.
Substitution approach: If the company has net book value (cost basis minus accumulated depreciation) figures for the asset readily available, it’s easy to use the substitution approach. In this case, the company removes the cost of the old asset and replaces it with the cost of the new asset.
Capitalization of the new cost: This approach leaves the old asset on the books and adds the cost of the new asset as well. Many times this isn’t any big deal because the net book value of the old asset is de minimis, or immaterial.
Charge to accumulated depreciation: If the process extends the useful life of the existing asset, the cost of the improvement goes to accumulated depreciation.
Now that you’ve gotten those explanations out of the way, it’s time to see how this looks in black and white. For example, ABC, Inc. pays $135,000 to replace some plant assets. The net book value of the assets is $10,000 (cost of $125,000 minus $115,000 accumulated depreciation).
The following figure shows how to journalize this transaction using the substitution approach.
Now, imagine that ABC, Inc., combined a bunch of plant assets on the balance sheet and doesn’t know the exact net book value of the plant assets being replaced. In that case, the only journal entry needed is to debit plant assets and credit cash for $135,000.
Finally, ABC, Inc., decides to pay $50,000 to beef up the old plant assets, which extends their useful life. In that case, the journal entry is to debit accumulated depreciation and credit cash for $50,000.