• Define capital expenditures and differentiate from revenue expenditures

 

When we write a check for a non-inventory item in our business, in the back of our minds we should be asking, should I expense this item or capitalize it?

To capitalize something means to record it as a fixed asset.

Capital expenditures are for fixed assets, which are expected to be productive assets for a long period of time. Revenue expenditures are for costs that are related to specific revenue transactions (product costs) such as COGS, or operating periods (period costs) such as rent, insurance, and even repairs and maintenance on machines and buildings.

Capital expenditures differ from revenue expenditures in the following ways:

• Timing. Capital expenditures are charged to expense gradually via depreciation and over a long period of time. Revenue expenditures are charged to expense in the current period or shortly thereafter.
• Consumption. A capital expenditure is assumed to be consumed over the useful life of the related fixed asset. A revenue expenditure is assumed to be consumed within a very short period of time.
• Size. A more questionable difference is that capital expenditures tend to involve larger monetary amounts than revenue expenditures because an expenditure is only classified as a capital expenditure if it exceeds a certain threshold value; if not, it is automatically designated as a revenue expenditure. However, certain quite large expenditures can still be classified as revenue expenditures, as long they are directly associated with revenue transactions or are period costs.

Consider the following three scenarios:

1. Your company buys a dozen tablet-sized inventory scanners for the purchasing department for $400 each, allowing the employees to better track inventory.
2. Your company executes a long-term lease for a $50,000 truck for the sales manager to use for business purposes.
3. Your company executes a sales agreement for a piece of land and hires a contractor to build a new retail sales distribution center for $1,000,000.

For each of these, the accountant asks, “Do I capitalize this purchase or expense it?”

An experienced accountant wouldn’t have trouble with scenario three: a piece of land with a $1,000,000 building clearly fits the definition of an asset, as we’ll see below.

Scenario two might be a bit trickier, and we might need more information, but if the lease looks more like a financing arrangement than a month-to-month rental, we would capitalize the car.

Scenario one might cause even an experienced accountant to pause for a moment. Are these fixed assets or a period expense? The answer, of course, is “it depends.” Most likely, your company has a policy stating that items looking like fixed assets are expensed if they are too immaterial to bother with, say, under $500. Even so, if you buy a batch of them, is the $500 for each one, or for the lot? Also, does the company want to track certain items that fall below the materiality threshold anyway, such as tablet computers (such as iPads) that might be easily “misappropriated”? Specific-use items like networked inventory tracking tablets are probably not going to be subject to employee theft, so the purchasing department tablet computers, though technically fixed assets, will probably be expenses as a period cost.

With capitalized assets, like a $500,000 piece of machinery that churns out product day after day after day for 10 years, we run into a slight accounting problem. How do we match the expense of the machine to the revenue?

If we capitalize the $500,000 investment and never record an expense, it sits on the balance sheet until it is completely used up (remember the definition of the word expense?), and then what? If we expense it when we buy it, we have a physical asset sitting in the factory that doesn’t show up on the balance sheet, but that shows up on the income statement as a huge period expense. Neither of those options reflect the actual operations of the business.

So, we allocate the cost of the asset over its useful life. In the above case, we could recognize $100,000 of expense every year for five years, instead of $0 expense or $500,000 in year one. We call that allocation depreciation.

Before we discuss depreciation though, we need to identify exactly what expenditures are capitalized (recorded as assets) as opposed to those recorded as period or product expenses.