Last editedAug 20212 min read
Known as CapEx for short, a capital expenditure is a fund used by a business to purchase, upgrade or maintain a long-term asset. There’s a major difference between how capital expenditure is accounted for and how other spending is accounted for, so it’s important for businesses to understand when and why capital expenditure should be used.
What is CapEx used for?
Capital expenditure is often used to start new projects or new investments, or to maintain or upgrade existing assets. Capital expenditure is recorded, or capitalised as payment for goods or services on the balance sheet, rather than being expensed on the income statement. If an asset has a useful life of less than one financial year, it should be expensed on the income statement instead of being capitalised.
When an expense is capitalised, it is shown on a balance sheet as an investment, rather than as expenditure. In order to capitalise an asset, the business must spread the cost of the expenditure over the useful life of the asset.
What is a long-term asset?
A long-term asset is a fixed, non-consumable asset and is typically a tangible asset. The most common examples of long-term assets include property, infrastructure and equipment. Generally, the asset will need to have a useful life of more than one accounting period (typically a year) to be considered long-term.
Intangible assets that may be considered a long-term asset include patents and licenses.
When a business purchases equipment or machinery or property like a warehouse, factory, office building or land, this can be capitalised on the balance sheet. It can also include furniture and fixtures, software company cars, and more.
CapEx vs. OpEx
While the capital expenditure budget is used to invest in long term assets, the operational expenses (OpEx) budget is used for day-to-day operational costs. This can be anything from printer paper to office rent and utilities to travel expenses. An operating expenditure is spent on things that wouldn’t have a useful life beyond a year, and these purchases are recorded as expenses on a company’s income statement, unlike capital expenditure.
Expenses, like operational expenses, are subtracted from revenue on the income statement in order to determine profit. On the other hand, capital expenditure is accounted for as an asset on the balance sheet, with only the deprecation of the asset appearing on the income statement.
Depreciation is used to help businesses earn revenue from an asset while expensing part of its cost each year that it’s used. Depreciation represents how much of an asset’s value is estimated to be lost over time. When filing their annual tax returns, a business can deduct the depreciation amount of the asset. Essentially, a company can write off the value of an asset over a period of time, instead of expensing the entire cost at the beginning.
The clear benefit of capitalising assets is that, in only displaying depreciation on the income statement, it can have a positive effect on profits. A company may find that in purchasing an office building – a capital expenditure – they’d be spending less in the long run compared to regularly paying rent on an office space – an operational expenditure.
It is at the discretion of the business to decide which costs are expensed and which are capitalised, but generally capitalising is reserved for long-term, high-cost assets. Of course, there are rules in place to ensure that a business can’t simply write everything off as a capital expenditure, but a lot of it comes down to the judgement of the business itself.
If the value of the asset will last beyond a year, it’s wise to capitalise the asset on the balance sheet, while if the asset is not a long-term investment, it’s best to report it as an operating expense.
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