Capital expenditure refers to the cost of purchasing fixed assets such as land, buildings, and machinery. In contrast, operating expenses are costs directly related to a business's ongoing day-to-day operations. Examples of operating expenses include utilities, wages, and raw materials. Capital expenditures can be substantial for many businesses. When you have capital improvements or new fixed assets, you need to account for those costs in your company's financial statements. Fortunately, accounting for capital expenditures is fairly straightforward when you know what information you need and which forms to use. This guide explains everything you need to know about capital expenditures to confidently account for them in your company's books.

What is a Capital Expenditure?

An item of capital expenditure is an investment in a fixed asset with a useful life longer than one year. Capital expenditures are recorded as assets on a company's balance sheet; some might be written off. Businesses record capital expenditures as expenses on the income or profit and loss statements. This can be done by differentiating between the two in the accounting process. Capital expenditures are often associated with acquiring long-term assets, such as real estate, industrial machinery, and computer systems. However, short-term assets, such as computers and furniture, can also be considered capital expenditures. In the accounting world, there are specific rules about what should be capitalized and what shouldn't. Suppose a company spends money on assets that are expected to last more than one year. In that case, those expenses are considered capital expenditures.

How to Recognize a Capital Expenditure

To account for an item of capital expenditure on a company's books, you must first determine whether it should be capitalized. To do this, you must determine two things: 1) Is the expenditure a fixed asset? 2) Is the asset's expected useful life longer than a year? If the answers to the above questions are yes, then you should account for the expenditure as a capital expenditure. You can do this by recording the asset's cost in the accounting system, then subtracting it from the company's cash accounts simultaneously. This will ensure that you record the asset's cost in the financial records while accounting for the cash spent on the asset simultaneously.

Capitalization vs. Inventory

While accounting for capital expenditures and inventory purchases requires similar steps, the two have significant differences. Capital expenditures are associated with purchasing long-term assets like machinery and buildings. These expenditures are recorded as assets on a company's balance sheet. While inventory is associated with purchasing short-term assets or goods that a company expects to sell within one year. Inventory is recorded as a current asset on a company's balance sheet. There are three main reasons a company might choose to capitalize a fixed asset but account for inventory as an expense. When determining whether to capitalize or expense a cost, businesses must determine if the cost meets any of the following criteria. An item of capital expenditure is a cost that meets at least two of the above criteria. If a cost meets just one of these criteria, it should be expensed as an operating cost.

Depreciating Assets

A company must account for the cost over time when it purchases a long-term asset. One of the most common ways to account for capital expenditures is by using the depreciation method. You can calculate the amount that should be allocated to an item of specific capital expenditure by multiplying the total cost of the asset by its planned useful life. The resulting figure should be recorded as an expense over the asset's life in the company's financial records. This will help the company account for the full capital expenditure over time.

Defining Events for Capitalization

Suppose a company purchases a fixed asset that meets the criteria for capitalization. In that case, it should be recorded on the books as a capital expenditure. Several events can trigger the capitalization of assets, including the following things. First is the purchase of real estate. Even if the real estate is not used as a commercial building, it is still considered a capital expenditure. Next is the purchase of equipment. Equipment is often considered a capital expenditure, even if acquired on a short-term lease. However, software purchased and installed on computers should be capitalized only if it remains in place for at least one year.

To Capitalize or Not to Capitalize?

Some may wonder if there is ever a time when a business should not capitalize on a fixed asset. While it is true that businesses have the option to not capitalize, it is rarely the best decision. Capitalizing a fixed asset means including it in the company's balance sheet and recording it as an asset. This will help the company account for the asset on its books and accurately reflect the value of the company. It will also help the company accurately calculate the depreciation of the asset. This is important because it will allow the company to track the asset's original cost and determine how much it is worth at any given time. Capitalizing on a fixed asset will help the company track its cash flow. This is important because it will decrease the company's cash balance. This will allow the company to accurately track its available cash and determine if it needs to seek financing.

Tangible Assets and Intangible Assets

When calculating the capital expenditure cost, businesses must determine if the asset is tangible or intangible. Tangible assets are physical items, such as machinery, vehicles, and furniture. Intangible assets are non-physical assets, such as intellectual property and licenses. Tangible assets must be capitalized in full. These assets are expected to have a useful life of more than one year and are expected to have a significant impact on the company's operations. Intangible assets must be capitalized if the cost of purchasing them is high. The cost of intangible assets is usually recorded as an expense on the company's books.

Computer Software Costs

When calculating the capital expenditure cost, businesses must determine if a software purchase is tangible or intangible. A software purchase must be capitalized in full if it is recorded as a tangible asset. - If the software purchase is recorded as an intangible asset, it will only have to be capitalized if the purchase cost is high. A high cost for intangible assets is $5,000 or more.

When are Software Development Costs Recoverable?

Sometimes, a business might incur software development costs that do not meet the criteria for capitalization. These costs should be recorded as an expense on the company's books. Suppose the business makes a capital expenditure that includes software development costs. In that case, the company should determine if the software is tangible or intangible. If the software is intangible, the company should determine if the purchase cost is high. If the cost is insignificant, the company should record the software development costs as an expense on the books. The company should determine if the software development costs are high or if the software is tangible. If they are, the company should capitalize the software in full.

Conclusion

It is important for businesses to accurately account for their capital expenditures to ensure that they have accurate financial records. When you account for capital expenditures properly, it will help you track the overall progress of your company. This will make it easier for you to forecast future growth and determine your business's current profitability.