What is Capital Expenditure?
Capital expenditure or CapEx is the expenditure incurred by the Company to acquire or upgrade or maintain tangible assets like plants and machinery, buildings, and other such equipment. And those are necessary for the manufacturing and/or provision of services by the Company.
It involves implementing greenfield projects, expansion or diversification of the current line of manufacturing, or any other major long-term investments. It covers an enormous range of expenditures, starting with repairing a building or the purchase of fixed assets and related expenses. The company incurs these expenditures in order to expand its scope of operations and ensure the smooth and improved functioning of the organization. In short, expenditures that are part of the balance sheet and not part of the income statement are referred to as capital expenditures. Or in other words, since these expenditures and assets created out of that has life running for long years, they are not debited to the profit and loss account because that relates to the operations of one year only.
- What is Capital Expenditure?
- Capitalization of the Expenditure
- Capital Expenditures vs. Operating Expenses
- What does it Explain?
- Classification / Types of Capital Expenditures
- Importance of Capital Expenditures
- Capital Expenditure Accounting
- What is Capital Expenditure (CapEx) Budget?
- Capital Expenditure (CapEx) Ratio
- Capital Expenditure (CapEx) Management
Capitalization of the Expenditure
As we discussed above, such expenditure gives a return over a long period of time. All such expenses need to capitalize and taken to the balance sheet. These expenditures over the period are written off as depreciation on the fixed assets. And thus, these expenses get debited to the profit and loss account over the life of the asset. Or till the expense will continue to give the benefit. But there is a subtle difference with regard to expenses on these assets. So, while the original cost and any additions thereon are capitalized, however, the expenses towards its repairs and maintenance of that asset to sustain its working during the year do not flow to the balance sheet. Instead, a direct debit happens to the current year’s profit and loss account, and thus write-off occurs in the current year itself.
The presentation of these investments happens in different ways in different financial records. They all flow to the cash flow statement under the category of investing activities, as it is a cash outflow for that particular accounting year. It is shown as expenses incurred like purchases of property, plant and equipment, PP & E, etc. And these all find a place as an asset in the balance sheet under the head “Property, plant and equipment.”
The requirement of capital expenditure depends on the type of industry and the project at hand. It varies from industry to industry. A capital-intensive company requires a higher investment. At the same time, a non-capital intensive company needs to incur a lesser amount of CAPEX. Further, in line with the accounting guidelines, each year, the assets get depreciated till the end of the useful life of that asset. Depreciation represents the wear and tear of that asset. (Read Capitalizing Assets to learn more).
Capital Expenditures vs. Operating Expenses
All the expenses can have two categories: CAPEX (Capital Expenditure) and OPEX (Operating Expenses)
Capital expenditures are long-term expenditures that have an earning / return effect beyond the current financial year. They mainly include expenditures for the purchase of fixed assets or investments with a life span of more than one year. They also include expenditures to improve the working life of assets or equipment. Or that may enhance the capacity of the asset. Capital expenditures are first taken to the balance sheet, and then depreciation provisioning happens over a period of time.
These are expenditures towards maintaining the day-to-day operations of an organization. They are usually short-term expenditures that cover the operating costs of running a company. And such expenditure lasts less than one year. Further, the debit happens for all these by the company in the same year in which it incurs it. And operating expenditures are directly taken to the profit and loss account or income statement.
The below table can give a brief idea of the key differences between the two:
|They are available for a longer period
|They are available for one period only
|Firstly recording happens on the balance sheet
|Directly flows to Profit and Loss Account or Income statement
|To acquire a new asset or make old ones reusable with improved efficiency
|Primarily to run the day-to-day business
What does it Explain?
It explains the amount spent on setting up the project or manufacturing facility and is displayed as long-term assets on the balance sheet. Long-term assets are usually physical, fixed, and non-consumable assets like property, equipment, or infrastructure. They have a useful life of more than one accounting period.
It also includes and indicates the expenditure on the purchase and improvement of long-term assets to increase the efficiency or capacity of the company.
Classification / Types of Capital Expenditures
The capital expenditure may have the following categories.
- Expenses towards maintaining the company’s current operations. Such as replacing old and inefficient machines with new ones.
- The incurrence of expenses by the company to increase future growth, such as the purchase of new equipment and machinery to increase the capacity and efficiency, and market potential.
- Research work expenses.
- All expenses that the company indirectly incurs for production have a long-term benefit.
- Expenditure for innovation.
Capital expenditure can be either tangible or intangible. Tangible includes purchasing machinery, plant, or equipment, while intangible includes expenses for patents, trademarks, goodwill, etc. It is particularly important to note that the expenses by the company for asset repair or asset maintenance are not part of capital expenditure. They are reported in the income statement when incurred.
Also, read – Capital Expenditure Formula
Importance of Capital Expenditures
Capital expenditures are crucial for a company. They are the backbone and starting point for creating any manufacturing facility. They directly help to increase and sustain the growth of a company. The other reasons for their importance are:
Effect for a Longer Tenure
Expenses that fall under the category of capital expenditure usually last beyond the current financial year in which they were incurred. The benefits extend for more than one year.
Irreversible Capital Expenditure
The amount spent on capital expenditure is so high that it is hard to reverse. And in costing terminology, “Sunk Cost” is the name given to such expenditures.
Capital expenditures are a major part of the total project cost, and usually, major funds remain blocked in these assets. Therefore, considering the quantum and long-term nature of these expenses, it is very important to incur them wisely, efficiently, and timely.
Since these assets do have a certain useful life and need replacement thereof, hence, the company has to write off the capital expenditures over the period of its useful life by way of regular depreciation provisioning. And thereby, funds accumulation happens over the years for timely replacements.
The following are some examples of capital expenditure:
- Purchase of tangible or intangible assets
- Expenses for the expansion of capacities such as the expansion of the building and improvements
- Costs incurred to make use of a non-functioning asset usable
- Repair the asset to use it again
- When acquiring a new business
- Hardware purchases such as computers, etc.
- Plant and equipment purchases
- Vehicles for the transport of goods
Capital Expenditure Accounting
Accounting for CAPEX is nothing other than the acquisition of the fixed assets by the Company. Hence, they are so placed on the asset side of the balance sheet under the Block of Fixed Assets. These assets undergo depreciation provisioning over their useful life, and this depreciation is then taken to the income statement. Depreciation calculation can happen in two ways: The Straight Line Method (SLM) and Written Down Value Method (WDV). At SLM, the asset depreciation amount remains constant over the life of the assets, i.e., the profit and loss account gets a debit of a fixed amount. Whereas under WDV, the asset depreciation takes place at a fixed rate (usually). In other words, under WDV, the rate remains the same, but the amount fluctuates year or year on a reducing trend.
Let us try to understand the accounting treatment of capital expenditure using an example: A company, X Ltd., bought a machine worth $50,000 with a service life of 8 years. And the company decides to write off the machinery by following the straight-line method over its useful life.
Now the Company will first record the machinery under the heading of fixed assets on the asset side of the balance sheet. And at the end of every year, it will depreciate by $ 6,250 ($50,000 / 8). And then will charge this depreciation to the income statement over the 8 years period.
The accounting entry to record the purchase of machinery will be:
|Vendor (for purchase on credit)
The accounting entry for depreciating the asset will be:
|Profit & Loss Account
What is Capital Expenditure (CapEx) Budget?
Since capital expenditure requires huge investment in assets, it is important for companies to prepare Capital Expenditure Budget for the optimal use of limited sources. Does it involve the decision regarding how to finance the capital expenditure? That is, whether funds should be raised through debt or whether the available cash balance of the company should be used. Capital expenditure leads to a blockage of funds, as receiving a return on such an investment is a time-consuming process. Therefore, it is important to set up and plan an appropriate budget for capital expenditure, considering all factors that can have an impact on it.
Capital Expenditure (CapEx) Ratio
The capital expenditure ratio calculation can happen on the basis of the benefits being derived from such expenditures in terms of operational cash flows. Therefore, Cash flows from the company`s operations get divided by capital expenditures to determine whether the investment is profitable or not.
A higher ratio is treated as a favorable sign of growth, and similarly, a low ratio is treated as an unfavorable sign of growth. It also indicates whether the company has sufficient cash flow to finance its capital expenditure program or it needs outside funding to implement the same.
Capital Expenditure (CapEx) Management
The management of capital expenditure is important on the part of the company management. Since improper management and execution of capital expenditure plan may lead to financial losses, liquidity crisis and put the company’s credibility at stake. A few things to consider for effective management of capital expenditure are:
- Prepare a detailed capital expenditure budget. And that should not have any overlap and mix up with other annual budgets.
- There should not be any confusion between capital expenditure and operating expenditure.
- Carefully analyze and assess the costs and benefits of the various proposals available. And then, based on that analysis, acceptance, and implementation of a particular should proposal be taken up.
- Ensure transparency in the authorization process.
(Read Capex Planning for more).
Capital expenditure is the long-term expenditure that a company spends on buying, improving, or expanding fixed assets. Its effects last for a long period. Since a significant amount is present in capital expenditure, it becomes very important to manage such expenses very wisely. Any mismanagement can play havoc with the company’s operations.
Capital expenditures are available on the asset side of the balance sheet. Also, one can see capital expenditures made by the company in the cash flow statement under the head of investing activities.
a. Routine repair and maintenance
b. Replacement of worn-out part
c. Installation expense of new machinery
d. Whitewash of the office building
Answer: c. Installation expense of new machinery
a. Painting delivery van @ $1000 after using for 2 years
b. Purchase of stationery for admin department
c. Interest paid
d. Freight paid for bringing equipment to the factory
Answer: d. Freight paid for bringing equipment to the factory
Capital expenditures are initially recorded in the balance sheet and then depreciated over their useful life by a debit to the profit and loss account.