By Madison Garcia Updated January 25, 2019
A capital expenditure is a purchase that a company records as an asset, such as property, plant or equipment. Instead of recognizing the expense for an asset all at once, companies can spread the expense recognition over the life of the asset. Assets generally look better on a financial statement compared to expenses, so many companies try to capitalize as many related expenses as they can. Generally Accepted Accounting Principles, or GAAP, provide companies guidance on how to record the initial purchase and subsequent asset expenses.
Time Frame
The Financial Accounting Standards Board, which sets the standards for GAAP, states that assets deliver a probable future benefit. On the other hand, expenses result in "using up" assets, such as cash, to produce goods and services. When a company makes a purchase, it can be difficult to determine if it is an asset or if it is an expense. For example, you could argue that a $50 printer could be an asset or an expense. To simplify the decision, GAAP states that purchases must have an expected useful life of more than one year to be considered capital expenditures.
Initial Setup
GAAP allows companies to capitalize purchases that bring the asset to a usable state. Often, the cost of a piece of equipment isn't the only cost a company has to incur to get operations running. For example, a company may have to pay a shipping company to deliver the machine, purchase shipping insurance and waste some materials in initial trial runs. All of these purchases are part of getting the machine to a workable state, so the company can capitalize all of them.
Improvements
Under GAAP, companies can capitalize land and equipment improvements as long as they aren't part of normal maintenance. GAAP allows companies to capitalize costs if they're increasing the value or extending the useful life of the asset.
For example, a company can capitalize the cost of a new transmission that will add five years to a company delivery truck, but it can't capitalize the cost of a routine oil change. Rules for land are similar; a company can capitalize the initial cost of sidewalks, signs and parking lots, but it can't capitalize the costs of mainlining these items.
Interest
If a company needs to take out a loan to construct a new asset, it can capitalize the associated interest expense. GAAP lays out a few stipulations for capitalizing interest expense. Companies can only capitalize the interest if they are constructing the asset themselves; they can't capitalize interest on a loan to purchase the asset or pay someone else to construct it. Companies can only recognize interest expense as they incur expenses to construct the asset. For example, if a company spends $7,000 in one period constructing the asset, it can capitalize the interest expense associated with that $7,000.
As an accounting expert with a wealth of experience in financial principles and Generally Accepted Accounting Principles (GAAP), I can confidently delve into the concepts discussed in the article by Madison Garcia on setting up a new business, specifically focusing on capital expenditures and their accounting treatment.
Capital expenditures, as outlined by GAAP, refer to purchases that a company records as assets, such as property, plant, or equipment. These assets provide a probable future benefit, and to enhance financial reporting, companies have the option to spread the expense recognition over the useful life of the asset. The key objective is to present a more favorable financial statement by capitalizing related expenses rather than recognizing them all at once as immediate costs.
One critical criterion, as stipulated by the Financial Accounting Standards Board (FASB) that sets GAAP standards, is that assets must deliver a probable future benefit. This is in contrast to expenses, which involve "using up" assets, like cash, to produce goods and services. To determine if a purchase qualifies as a capital expenditure, GAAP requires that the asset has an expected useful life of more than one year. This ensures that the company is investing in long-term assets rather than short-term consumables.
The initial setup phase is also crucial in the capitalization process. GAAP permits companies to capitalize not only the direct cost of the asset but also related expenses that bring the asset to a usable state. This includes expenses such as shipping, insurance, and initial trial runs, all of which contribute to making the asset operational.
Furthermore, GAAP allows companies to capitalize costs associated with improvements to land and equipment, provided these improvements go beyond routine maintenance. If the improvements increase the value or extend the useful life of the asset, they can be capitalized.
Interest expenses incurred during the construction of a new asset can also be capitalized under GAAP, but with specific conditions. The interest can only be capitalized if the company is constructing the asset itself. It cannot be capitalized for loans used to purchase the asset directly or pay someone else for construction. Additionally, companies can only recognize interest expenses as they incur costs for constructing the asset.
In summary, the concepts of capital expenditures, initial setup, improvements, and interest capitalization are integral aspects of accounting practices outlined by GAAP, ensuring companies adhere to standardized principles when recording and reporting their financial transactions.
