A capital expenditure (“CapEx” for short) is the amount a company spends to buy long-term physical or fixed assets. Today’s blog will discuss capital expenditures and how to tell the difference between CapEx and regular business expenses.
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5 Second Take Away: Capital Expenditures
- We use the term capital assets to describe assets used in operations with initial lives extending beyond a single reporting period. Capital assets may be either intangible (e.g., easements, water rights, licenses, leases) or tangible (e.g., land, buildings, building improvements, vehicles, machinery, equipment, and infrastructure).
- Capital expenditures are the money a company spends on property, plant, and equipment to reinvest in its business.
- We consider capital expenditures investments in the future.
- A capitalization threshold is a minimum cost at which an asset is reflected in your accounting records and financial statements.
- Due to their substantial initial costs, irreversibility, and long-term effects, capital expenditure decisions are critical to an organization.
What Are Capital Expenditures?
When a company uses capital expenditure, it refers to money used to purchase, improve, or maintain long-term assets. So whether it’s to improve the efficiency or capacity of the company, the end goal is the same.
Also known as CapEx or capital expenses, these long-term assets are typically real, physical, fixed, and non-consumable. Examples include property, equipment (i.e., machinery), infrastructure, business vehicles, and furniture. On the other hand, capital expenditures can also include intangible assets like patents or licenses.
Examples of Capital Expenditures
- Buildings (this also includes the costs used to extend the useful life of a building)
- Computer equipment
- Office equipment
- Furniture and fixtures
- Intangible assets (such as a purchased taxi license, a patent, or goodwill)
- Land (including costs to upgrade the land, such as the cost of an irrigation system or paving/]plowing a parking lot)
- Machinery (including the fees required to bring the equipment to its intended location and for its intended use)
- Software
- Vehicles
Quantifying Capital Expenditures
The amount a company spends on capital expenditures’ is disclosed as a line item in its cash flow statement.
As a result, the cash flow statement paints a picture of how a company’s operations are running, where its money comes from, and how it spends money.
The Impact Of Capital Expenditures
Capital expenditures typically significantly affect a company’s short-term and long-term financial standing. Hence, making wise CapEx decisions is vital to a company’s financial health. Because of this, many companies keep extensive records of capital expenditures; this is helpful for investors.
In addition, it shows that managers are committed to the company’s growth as they continue to reinvest the money.
What is a Capitalization Limit?
A capitalization limit (“cap limit”) is the threshold above which a company capitalizes on purchases or constructed assets.
Any amount below this limit, purchases are generally categorized as expenses instead. Companies set capitalization limits to stop wasting time tracking assets with little value, like computer keyboards, tablets, or e-readers.
Determining A Capitalization Limit
As you may or may not know, a business has no specifically required cap limit. Because of this, cap limits vary considerably among industries.
For example, a smaller company with few expenditures might set a cap limit of only $1,000, whereas a larger business may prefer a high limit, such as $50,000. Given that larger companies may be overwhelmed by the recordation requirements of fixed assets, they tend to go this route.
NonprofitsOn the other hand, nonprofits may prefer a low capitalization limit to keep close track of their assets.
However, many businesses find that a capitalization threshold of about $5,000 balances the offsetting issues of avoiding excessive record-keeping and charging large items to expenses as incurred.
Consequences When The Capital Expenditure Limit Is Too Low
Additionally, there are consequences if a cap limit is set too low. And the impact is twofold. Firstly, the government will charge you higher income taxes as expenditures get shifted into fixed assets.
As a result, the short-term profits look higher. These changes result in a cash outflow in the form of tax payments that would not have been present if a higher cap limit had been used.
Secondly, in time, these items still get charged as expenses. So, in addition to the illusion of higher short-term profits, a low cap limit increases the depreciation expense in later years.
Finally, I’d be remiss not to mention the impact on your tax bill. Setting a low cap limit creates a sizeable fixed asset register and exposes you to a significant personal property tax bill.
Consequences When The Capital Expenditure Limit Is Too High
Alternatively, with a cap limit set too high, there’s a minimal amount of fixed assets to record. As a result, a more significant number of big-ticket purchases are charged as current-period expenses. As a result, profits will appear lower than they are.
When to Record an Expenditure as an Expense?
When to Set a Low Capitalization Threshold
It makes sense that some industries, such as nonprofits and the first response industry, set low cap thresholds. For starters, it makes sense for them to keep close track of lower-cost assets for high levels of record keeping.
For example, a hospital may capitalize oxygen delivery units in ambulances to record the units’ locations accurately.
Final Thoughts
Major capital projects involving vast amounts of money and capital expenditures can get out of control quickly if mishandled and cost an organization a lot of money. I worked for an oil and gas company that didn’t take the time to plan and execute a large-scale project. Eventually, the project was scrapped with 2 billion dollars down the drain!!!!! However, that doesn’t have to be the case. A company can and will thrive with adequate planning, the right tools, and good project management.
