Generally, capital expenditures are not recorded in the income statement. It’s because the income statement is relevant for a short period. On the other hand, the capital expenditure is incurred for more than on accounting period. Hence, if we classify capital expenditure in the income statement, it will violate the matching concept and lead to inadequate financial reporting.
However, it’s important to note that revenue expenditure is only incurred for a single period. Hence, it must be recorded in the period of occurrence.
Income Statement and CAPEX
The income statement reports depreciation every year and reduced profit. Income statement does not immediately reflect CAPEX purchases. Instead, it is viewed on the balance sheet as an asset that is depreciated as an expense over time, beginning the year after the item is purchased.
So, depreciation allocates the cost of an asset as an expense in the different accounting periods. It’s because the economic benefit of capital expenditure is obtained in different accounting periods.
Let’s have a detailed understanding of the capital expenditures.
Property, plant, and equipment (PP&E) constitute long-term tangible assets that businesses purchase, upgrade, or improve. These expenditures are crucial to companies’ growth and maintenance. Capital investments are seen as investments into the company’s ongoing operations, not as expenses on the income statement. Following are some of the examples of capital expediture:
- Office buildings
- Equipment and machinery
Types of Capital Expenditure
There are two types of CAPEX expenditures, and they include tangible, and intangible assets.
Physical assets, fixed assets, and non-consumable assets with a long lifespan typically belong to this category. These assets include:
- Massive maintenance (leading to increased life), renovation, and the purchase of land, property, or a building.
- A manufacturing enterprise’s acquisition of manufacturing equipment, machinery, and plants, along with upgrades, repairs, and depreciation.
- Another capital expense related to the delivery of goods is vehicle purchase, which includes maintenance, repair, and depreciation charges.
- Costs associated with the purchase, installation, and maintenance of computers, laptops, and peripheral devices.
It’s important to note that expenditures incurred to bring an asset in the usable form are also included in an asset’s cost. And once an asset comes in the usable form, depreciation has to be applied irrespective of the fact that an asset is used by the business or not (it’s in line with the International Accounting Standard -16). This IAS provides guidance for recognizing, depreciation, revaluation, and other aspects of Property plant and equipment.
It takes more than one fiscal year to realize the value of non-physical assets. Capital expenditures are also included here. Capital expenditures in this category generally include:
- Software acquisition and upgrade,
- Protecting technology, products, and services through patents and copyrights
- Goodwill (only recognized when business is purchased)
- While taking over another company
- The fee for registering a license.
The cash flow from investing activities can be used to determine capital expenditures from a company’s cash flow statement. A BASE calculation can be used for net PP&E and rearranged for CAPEX. The ending amount of net PP&E is calculated during the current balance sheet year by comparing the beginning amount of net PP&E and its changes during the prior year. We calculate net PP&E as follows:
B: beginning as it includes prior year property, plant, and equipment
A: Addition as it includes the addition of capital expenditure
S: subtraction as it includes depreciation
E: Ending as it includes reported property, plant, and equipment
Capital Expenditure Accounting
An asset must be capitalized if the acquired property’s use exceeds the company’s taxable year. The cost of this acquisition does not appear immediately on the profit and loss statement of the company. Rather than the costs being spread over an asset’s useful lifetime as a result of the amortization and depreciation process. Following are the impacts of incurring capital expenditure for the business.
Costs associated with capital expenditures are accounted for fully on the asset side of the balance sheet. Consequently, noncurrent assets increase. At the same time, CapEx reduces the company’s cash flow in general. So, if an asset is purchased with cash, the amount of total assets remains the same.
As a result of amortization or depreciation, capital expenditures for the company are expensed out from profit and loss statements of the subsequent years. It’s important to note that depreciation is a non-cash expense mostly applied using straight line and reducing balance methods.
Cash Flow Statement
Purchase of CAPEX results in a reduction of cash balances, a reduction in the balance sheet is reflected (although total assets remain the same if CAPEX ispurchased with the cash). The cash flow statement, therefore, reflects the expenditure by showing outflow. This is also mentioned in the section on investing, which includes the acquisition of property, plant, and equipment.
CAPEX and Operational Expenses
Capital expenditures (CAPEX) refer to the money spent on acquiring assets that will be used for more than twelve months. In contrast, operational expenses refer to the cost of running a business.
The CAPEX investments appear under the investing section of the cash flow statement. In contrast, operational expenses appear on the income statement, and the corresponding amount appears on the balance sheet.
CAPEX purchases are often accompanied by immediate income statement impacts as depreciation needs to be charged, depending on what assets are purchased. Although depreciation expenses could be offset by the increased sales activity that may result from the business’s expanded capability, these expenses may actually be offset by an increase in revenue due to the purchase of CAPEX.
Capital expenditure is incurred for more than one economic period. Hence, there is a need to allocate assets in different accounting periods. The allocation is in line with the requirement of the matching concept that requires expenses to be recognized in the period of occurrence.
On the other hand, revenue expenditure is incurred for a specific period under consideration. Hence, there is no need to allocate amount over different periods. Instead, total expense is charged in the period of occurrence.
At a time of quiring capital assets, there is no impact on the business’s income statement. However, depreciation needs to be charged in the different accounting periods depending on the asset’s useful life
If capital expenditure is made by paying cash. In that case, the total asset on the business’s balance sheet remains the same as the cash asset is replaced with the capital asset under consideration.
The capital expense can also be incurred on intangible assets. The example of intangibles as capital expenditure includes but is not limited to goodwill, software acquisition, patent, and any other asset acquired that does not have physical existence. However, it helps in acquiring economic benefits.
Frequently asked questions
What’s the difference between revenue and capital expenditure?
Revenue expenditure is expected to drive value for one accounting period only. The value is driven in the period of occurrence. On the other hand, capital expenditure is expected to drive value for a time more than one accounting period.
In the cash flow statement, where is capital expenditure shown?
Capital expenditure constitutes the outflow of cash from the business. So, it shows as cash outflow under-investing business activities of the cash flow statement.
Is there any impact of depreciation on the cash flow?
There is no direct impact of the depreciation expense on the cash flow statement. However, if you prepare a cash flow statement with an indirect method, depreciation needs to be added back to the profit as it’s a non-cash expense.
What is tax depreciation?
Tax authorities do not accept accounting depreciation as a deductible expense or taxable income. It’s because it comes with multiple assumptions and judgments. Instead, tax authorities allow tax depreciation, leading to a difference in the accounting and tax base, resulting in deferred assets or liabilities.