What do we mean by Capital Expenditure Accounting?
Capital expenditure is the expenditure for buying long-term fixed assets in an organization. The expenditure can also be on improving and extending the life of such assets. These assets have a life cycle of a year or more. Such assets are usually fixed in nature and include land, building, furniture and fixtures, plant and machinery, etc. Sometimes a company may incur capital expenditure on non-tangible assets such as patents and licenses, trademarks, software, and even technology. Capital expenditure accounting is the treatment of such expenditure in the books of accounts of an organization. Since a capital expenditure involves a substantial sum of money and resources, its treatment in the books of accounts becomes tricky and very important.
Capital expenditure or CapEx decisions may be taken as an expansionary measure to enhance or improve the already existing business activities and their scope. The expenditure can also be undertaken for a completely new project or for making new acquisitions. Such expenditures help a business to stay ahead of the competition and maintain its supremacy. The amount of capital expenditure that an organization will require normally varies from industry to industry. High capital-intensive industries such as manufacturing, power generation, telecommunications, oil exploration and rigging, refineries, etc. require very heavy capital expenditures frequently. On the other hand, service industries normally require low capital expenditure. In any case, businesses should constantly incur capital expenditures every year to progress and grow. Also, it is an indication that the management is reinvesting the profits of the business back in it for its betterment.
How do we do Capital Expenditure Accounting?
We do not treat capital expenditures as an expense because of their large outlay as well as the number of years of use. Hence, they are not a part of the income statement. We treat such expenditure as an asset. It finds its place in the Balance Sheet of the company under the head- Fixed Assets. Often companies have a “capitalization limit”. We treat any asset that costs less than this limit as expenditure in the income statement. This happens in the financial period the company incurs it. The assets that cost more than this limit go to the Balance Sheet.
We report the capital expenditure in the cash flow statement in the financial period in which it occurs. Since cash flows out of the company for such expenditure, it is shown as a cash outflow or a negative amount in the statement. Capital expenditures are shown under the heading “cash from operating activities” as an outflow to calculate the company’s free cash flows.
Capital expenditure and operating expenditure
There are some forms of expenditures that might seem to be operating expenditures but are a part of the capital expenditure. For example, if we renovate a major portion of the factory building and the company incurs substantial expenditure in the process, we should capitalize this expense and add it to the value of the factory building. On the other hand, simple repairs and maintenance expenditures do not form a part of the CapEx. Hence, we should include them in the income statement as an expense. There are a number of such expenditures. It is up to the management’s discretion to classify them as capital expenditure or operational expenditure.
Another important point to note is that we should not term an asset with a useful life of less than a year as a capital expenditure. So such an asset should not become a part of the Balance Sheet. This expense should be shown in the Income statement, no matter how big the amount is.
Capital expenditures do affect the income statement, though in an indirect way in the form of depreciation or amortization expense. Depreciation is the fall in the value of any tangible asset with a company over a period of time. This reduction in value occurs because of the usual wear and tear of the asset with usage over the financial year. Similarly, we amortize intangible assets and charge this expense in the income statement. This happens from the next year of the purchase of the asset and continues over the useful life of the asset, till its residual value becomes zero.
One important point to note is that land is not subject to depreciation, although it is a major capital expenditure. This is so because the useful life of the land is infinite. Also, the value of land should appreciate over the years rather than depreciate due to its scarce nature and limited availability. Therefore, the capital expenditure on land does not find any bearing on the income statement of the company.
Let us understand how we charge depreciation amount in the Income statement against an item of capital expenditure. A company XYZ Pvt. Ltd. purchases new machinery worth US$ 100000 in March 2019. In November 2020 it makes a capital expenditure of US$50000 for a software up-gradation. The company has a policy of charging 20% depreciation every financial year by adopting the straight-line method.
Depreciation expenditure to go to the Income statement for the year 2020: 20% of US$ 100000= US$ 20000.
Depreciation/ amortization expenditure for the year 2021: 20% of (US$100000 +US$ 50000)
= US$ 30000.
The residual value of the machinery in the Balance Sheet at the end of financial year 2020=
US$ 100000 less US$ 20000= US$ 80000.
The company will keep charging US$ 20000 in the Income statement as depreciation expense for the next five years of the purchase of machinery. At the end of five years, the residual value of the machinery will become zero and it will stop being a part of the Balance Sheet.
Similarly, the company shall charge US$ 10000 as an amortization expense for the software up-gradation every financial year till its residual value becomes zero.
Capital expenditure accounting is very important for each and every organization across the world. Every company invests in fixed assets and engages in capital expenditure on a frequent basis. Incorrectly treating such expenditure in the Income statement will result in negative income or net loss in the financial statements. Hence, they should be properly accounted for in the books of accounts to reflect their true value. It is imperative on the part of the management too to correctly classify such expenditures into capital and operational expenditure. Because it will have a bearing on the income statement results, the organization’s tax liability as well as its Balance Sheet.