Accounting for Capital Expenditure
Accounting for capital expenditures can be difficult because of the details and technical issues involved. Capital expenses are usually related to large purchases, such as real estate and heavy equipment--items to be kept on a long-term basis. Capitalization can also apply towards research and development costs.
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Significance
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Capitalization affects net income. Suppose a business purchases a major equipment. If this equipment is expensed, it will decrease net income. However, if this equipment is capitalized, net income will not be affected as much. For example, if a major equipment is purchased for $100,000 and expensed, net income will decrease by $100,000; however, if the same item is capitalized, net income will decrease only by the depreciation related to the equipment, which is a smaller amount.
Assets
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Capitalized expenditures are booked as assets--instead of debiting an expense, an asset account is debited. Capitalized expenditures are presented in the financial statements as part of the balance sheet. Capitalized items are usually shown in three lines, with the first line presenting the type and cost of the asset. The second line shows "accumulated depreciation," decreasing the asset cost. The third line shows the "book value" or "net book value" of the asset-- asset cost less accumulated depreciation. Many firms present only the net book value of assets, excluding details.
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Expenses
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Once an expenditure is capitalized, it needs to reflect its long-term value on the income statement. This is done through depreciation, where an amount is recognized as an expense, decreasing net income. Depreciation is calculated by taking into consideration the asset's cost, estimated life and salvage value, and the depreciation methodology. For example, you could have an equipment costing $10,000 with an estimated life of five years, and no salvage value. Using the straight-line method for depreciation and assuming you bought the equipment in the beginning of the year, your annual depreciation expense would be $2,000 per year ($10,000/5 years). Net income would decrease by $2,000 each year for five years.
Regular Maintenance
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Once an item is capitalized, any regular maintenance on the item, such as cleaning or oiling, is expensed, not capitalized. You may capitalize certain maintenance expenditures only if it significantly increases the asset's life, makes substantial change to it or adapts it to a different use. Accountants usually need written documentation to justify capitalizing maintenance charges.
Journal Entries
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When an expenditure is capitalized, a few typical journal entries are used as the item is purchased, expensed through depreciation, and eventually disposed of.
A journal entry related to a purchase usually contains a credit to cash and a debit to an asset account. If the item was acquired on account, then the credit would go towards an account payable. If this item was originally recorded as an expense, then the correcting journal entry would be a credit to the expense and a debit towards an asset account.
As depreciation is recognized throughout the life of the asset, a debit is applied towards depreciation expense and a credit is used on an accumulated depreciation account in the balance sheet.
When an asset is disposed, the accountant debits accumulated depreciation, credits the asset account and debits or credits any gains or losses on disposal. If the asset is sold, then cash or accounts receivable should be debited too.
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References
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