Physically they are subject to improvement, betterment, repair, renewal, replacement, alteration, depreciation, assessment, and destruction. Of these, the questions of assessment for taxes and of depreciation are of such importance that they will be discussed in detail later on.
As to the title, buildings may be affected by encroachment, encumbrance, restriction, non-payment of taxes, and through liens obtained by builders or other judgment creditors. The courts will usually grant what is known as a builder’s lien in cases where a builder remains unpaid for material furnished in the construction of the building. Equal protection is afforded to the laborer through what is known as the mechanic’s lien.
The terms, improvement, addition, alteration, repair, renewal, and replacement are used somewhat promiscuously in bookkeeping and accounting. They should be used with a great deal of care. Such care can only be exercised by giving thought to the meaning of the various terms. The basis for decision in each case should be one of value rather than cost.
An improvement signifies an increase in value. Nothing should be recognized as an improvement which does not add value to the property. Adding value usually carries with it the thought that the earning power of the property is increased, although not necessarily. It distinctly implies value added to that which previously existed.
In connection with improvements, two questions arise. First, is the improvement permanent in its nature? Second, is the improvement temporary in its nature? Both questions are practically answered by determining whether the property involved is owned or rented.
If the property is owned, the improvement usually becomes a permanent addition, subject, like that to which it was added, to destruction by time and use. If the improvement is made to rented property, then the question of permanency, or of the life of the added value, is fixed by the terms of the lease.
Fire escapes, for example, might constitute the improvement in a given case. If the building were owned, there would probably be no doubt about the practice of capitalizing the improvement and subsequently writing the cost down along with the remainder of the building. If such an improvement were made to rented property, the treatment of such an addition would depend upon the terms of the lease. One of two things would probably be true; either the owner would allow the tenant a certain amount for the improvement at the expiration of the lease, or it would pass at such time to the owner of the building. If the former were the case, and the amount, as usually happens, could be determined sufficiently in advance, then there should be written off over the period covered by the lease, or the balance of the period of its life, an amount equal to the difference between the original cost of the improvement and the amount to be allowed by the owner of the building.
The accounting procedure would be similar in case, if no allowance were to be made by the owner at the expiration of the lease, except that the amount to be written off over the number of years covered by the lease would be the entire cost of the improvement, rather than the net amount, as in the preceding case.
Additions are practically synonymous with improvements. They are subject to the same qualifications concerning owned and rented property and to similar treatment after determining whether they are permahent or temporary in their nature.
Repairs should convey to the mind, restoration to the original condition after deterioration or impairment. They seem to differ from renewals and from replacements principally in extent. They may be termed minor renewals. They involve such work as is necessary to maintain the subject to which they are applied in its original state of efficiency, or of appearance.
The relation of repairs to renewals and replacements may perhaps be seen more clearly by taking a shingle roof, for example. The roof loses its efficiency when it begins to leak. It is failing to perform the function for which it was partially intended, namely, to keep out the water. The efficiency of the roof may be restored by patching the holes. This is repairing the roof and answers the purpose until the holes become so numerous that a renewal of the entire roof becomes advisable. It might be said with equal truth that the old roof had been replaced.
Thus, while the roof might have been repaired, or renewed or replaced, no value has been added to the building for the reason that in either case, the cost of the repair or renewal has merely been in connection with the restoration of the roof to a condition represented by the original cost. The cost of the repair or renewal becomes an expense and is chargeable to the upkeep or maintenance of the building.
The general rule above mentioned is subject to qualification in certain instances and under certain conditions. In the case of renewals or replacements, if the material replaced has a salvage or scrap value, it is usually considered proper to reduce the expense of the renewal by such value and charge to up-keep or maintenance the net amount.
On the other hand where the material used to replace the old is different in its character, or of better quality, there would seem to be no objection to charging a part of the expense to maintenance and capitalizing the remainder. The division is arrived at by a comparison of values of the two kinds of material and capitalizing the amount by which the value of the new material exceeds the old.
This point is well illustrated by a railroad, which replaces sixty pound rail with eighty pound rail. Using one rail, as an example, the cost of the new eighty pound rail would be divided into two parts; one part, corresponding to three-fourths of the cost of the eighty pound rail, which would be chargeable to maintenance and the other part, corresponding to the remaining one-fourth of the eighty pound rail which would be chargeable to cost of road.
Alterations may partake either of improvements or repairs. An alteration constitutes a change. Changing the doors of a room does not seem to add any material value to the room. It may render the room better adapted to the needs of the occupants. Putting a partition in a room seems slightly different in that it makes one room do the work of two. In the first instance the alteration would seem to constitute a repair, while in the second instance it appears to partake rather of an improvement. The accounting procedure would in such cases be governed by the interpretation which was placed upon the work.
The possibility of their being destroyed adds an interesting phase to the discussion of buildings. Earthquakes, floods, cyclones and fires are among the dangers at times besetting buildings. Their destruction may be partial or complete. It is brought about more frequently by fire than any other cause. Thus the discussion may profitably center around destruction by fire but the effect upon the accounting will be the same in any case, except as to the insurance.
Ordinarily the loss or destruction of an asset means a credit to the asset account and a charge to profit and loss. If buildings are not insured such will be the procedure in case they are destroyed. As a rule buildings are probably not insured as to earthquakes, floods and cyclones. They are usually insured against fire. Their partial or entire loss through any of the first three named causes would result in a charge to profit and loss in the amount of the loss. When insured, as in the case of fire, the accounting depends upon the circumstances. If the building is restored to its original condition by the insurance company, no entry is necessary. If a cash settlement is made by the insurance company the situation is altered. The owner of the building may decide to restore the old building in the case of an entire loss or he may decide not to rebuild.
Where an insured building is entirely destroyed, the situation, so far as the owner is concerned, is that he has converted his building into cash in an amount equal to the loss fixed by the insurance company. He has at his disposal a cash fund out of which he may rebuild. If the amount is equal to the book value of the building the procedure is simple; cash would be debited and the building account would be credited. Following the transactions historically in such a case, it might be advisable to interpose another entry. If the payment of the cash by the company was not concurrent with the notification of the amount of loss allowed, then it would be proper to charge the company with the amount allowed and adjust the building account, closing out the account with the company subsequently when the cash was received.
The same thing might happen in the case of a partial loss. In such an event the adjustment of the building account presents greater difficulties. Suppose that on a building costing $25,000 the company on a partial loss allowed and paid in cash $5,000. The general cash account or a special insurance fund account would be debited and the building account credited in the amount of $5,000. While this is the amount of the loss as fixed, by the company, it does not necessarily follow that $5,000 will repair the damage. If it would, the proposition would be simple. As the cash was expended and the cash account credited the building account would be charged and thus the value restored to the account. But supposing the cost of restoration was $6,000 instead of $5,000, would the entire $6,000 be charged to the cost of the building? It would not. What really happened was, that the loss was underestimated by the insurance company and that while it allowed only $5,000 the loss in reality was $6,000. The credit to the building account should have been $6,000, of which $5,000 should have been charged to cash while the $1,000 was charged to profit and loss. Obviously it is impossible to foresee such results so that the proper end is finally attained in partial loss by charging disbursements from the cash or insurance fund to the building until they have reached the amount allowed by the company, after which any further payments are charged to profit and loss.
As to the disposition of buildings it may be said that they may be disposed of by sale, or transfer, or demolished. If sold, such sale may be for cash or on credit. When on credit it may stand in an open account or be represented by a mortgage.
Where buildings are erected on leased ground, the question of their value at the termination of the lease becomes a problem. While it may be the intention, especially where the buildings are of an expensive and permanent character, that the lease will be renewed from time to time for long terms of years, eventually some one will have to face the problem.
The disposition of such property is usually covered by the lease, and while perhaps no general rule of practice can be stated, in many cases the lease provides that the buildings shall be appraised and that the owner of the land shall have the option of purchase at the appraised value. Where such is the provision and the owner of the land fails to exercise his option, the owner of the building may be under the painful necessity of moving the buildings, or having them demolished.
Where it is stipulated that the owner of the land shall purchase the buildings at an agreed price, it is customary, if such price be lower than the cost, to write down the excess over the period covered by the lease.
Applied Theory Test Number Four
The New York Foundry Company, located at Mt. Vernon, N. Y., on the main line of the N. Y, N. H. & H. Railroad, leased on January 1, 1909, for a term of five years a plant well adapted to its needs, except that there was no railroad siding.
The Company expended $2,000 in constructing such siding with the understanding that at the termination of occupancy the siding should pass to the owners of the property.
Frame the entries covering such a case.
Assume that, having proceeded with the accounting under the theory that the lease was to terminate at the end of five years, you were informed near the end of the period that the lease had been renewed for five years, how would the situation be affected?
Assume that the lease provided that the improvement was to be taken over by the landlord at the expiration of the original lease at a valuation of $1,200, payment therefor to be spread over the terms of the lease by deduction from the rent. The rent was $6,000 a year. Frame an entry covering the transactions for any given year.
Applied Theory Test Number Four
Jennings & Company leased a four-story building on University Place for a term of twenty years, paying therefor an annual rental of $12,000. The firm occupied the first, second and fourth floors, sub-letting to another tenant the third floor at art annua] rental of $2,400. During the first year of occupancy Jennings & Company expended $20,000 in alterations and fixtures with the understanding that certain partitions and other fixtures might be removed upon the expiration of the lease.
At the beginning of the eleventh year Jennings & Company moved to a building on Murray Street, taking with them fixtures valued at $4,000 and renting the space which they had occupied in the University Place building to various tenants at annual rentals aggregating $6,000. In order to secure desirable tenants it was necessary to expend $2,000 for alterations which it was understood would revert to the landlord upon expiration of the lease.
One sub-tenant at University Place whose occupancy began January 1, 1910, and whose annual rental was $960 paid his monthly rent for December, 1910, in advance. The remaining tenants did not pay for December until January, 1911. One of these latter, on a ten-year lease at $600 per annum, for whom alterations amounting to $600 were made in January, 1910, agreed to pay for the alterations in equal monthly installments extending over the period covered by the lease.
Frame the entries covering the alterations to the University Place building for the year 1910 and show the net income on the building for the year.
Applied Theory Test Number Four
The Bundy Manufacturing Company carried its buildings at $75,000. The buildings were designated by the letters A-B-C and D. The values were respectively $30,000, $15,000, $20,000 and $10,000. The equipment in building A cost $3,000; building B, $7,000; building C, $8,000; building D, $500. The plant was insured for $100,000.
On December 31, 1910, a fire occurred involving buildings A, B and C. The insurance adjusters visited the scene of the fire on January 2, 1911, and the insurance company subsequently offered the following settlement:
Building A, including equipment $13,000
Building B, including equipment 18,000
Building C, including equipment 22,000
The insurance company offered to make a cash settlement on building A. On building C it undertook to restore the building itself. On building B it agreed to approve bills for restoration up to the amount offered in settlement. The offers were all accepted on February 5, 1911, and the cash on building A was received February 6, 1911.
The restoration of building A, including equipment, cost $12,500. The restoration of building B, including equipment, cost $22,500, but included certain improvements valued at $2,500.
Frame the entries necessary to record the transactions historically.
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