Whether to Expense or Capitalize An Expenditure

A capitalized cost is an expense that is added to the cost basis a fixed asset on a company’s balance sheet. Capitalized costs are incurred when building or financing fixed assets. Capitalized costs are not expensed in the period they were incurred but recognized over a period of time via depreciation or amortization.

A fixed asset is a long-term tangible piece of property that a firm owns and uses in its operations to generate income. Fixed assets are not expected to be consumed or converted into cash within a year. Fixed assets are known as property, plant, and equipment (PP&E). They are also referred to as capital assets.

Cost vs. Expense

When trying to discern what a capitalized cost is, it is first important to make the distinction between what is defined as a cost and expense in the world of accounting. A cost on any transaction is the amount of money used in exchange for an asset. A company buying a forklift would mark such a purchase down as a cost. An expense is a monetary value leaving the company, this would include something like paying the electricity bill or rent on a building.

The decision of whether to expense or capitalize an expenditure is based on how long the benefit of that spending is expected to last. Costs should be capitalized or recorded as assets when the costs have not expired and they have future economic value. Theoretically, 1 year is taken as a time-limit, but that is only theoretically. If the benefit is less than 1 year, it must be expensed directly on the income statement. If the benefit is great than 1 year, it must be capitalized as an asset on the balance sheet.

For example, the purchase of office supplies like printer ink and paper would not fall under-investing activities, but instead as an operating expense. The purchase of a building, by contrast, would provide a benefit of more than 1 year and would thus be deemed a capital expenditure.

Expense is a cost whose utility has been used up, it has been consumed. For example, the $40,000 car you purchased will eventually be charged to expense through depreciation over a period of several years, and the $25 product will be charged to the cost of goods sold when it is eventually sold. In the first case, converting from an asset to an expense is achieved with a debit to the depreciation expense account and a credit to the accumulated depreciation account (contra account that reduces the fixed asset). In the second case, converting from an asset to an expense is achieved with a debit to the COGS account and a credit to the inventory account. So, in both cases, we have converted a cost that was treated as an asset into an expense as the underlying asset was consumed. The automobile asset is being consumed gradually, so we are using depreciation to eventually convert it to expense. The inventory item is consumed during a single sale transaction, so we convert it to expense as soon as sale occurs.

Cost of Goods Sold (COGS) vs. Operating Expenses

When an income statement is generated, the cost of goods sold and operating expenses are shown as separate line items subtracted from total sales or revenue. OPEX are expenditures that are not directly tied to the production of goods or services. Typically, selling, general and administrative expenses (SGA) are included under operating expenses as a separate line item. SG&A expenses are expenditures that are not directly tied to a product such as overhead costs. Businesses incur several different costs that are independent of the level of sales they produce. For example, a coffee shop must continue to pay rent, utilities, and employee salaries on its facilities even if customers are not buying any of its beverages. Operating expenses are the recurring costs that are not directly related to actual goods.

CapEx vs. OpEx Argument

Opex is short for ‘operational expenditure’ and refers to expenses a business incurs in its day to day operations. Operational expenditures such as expenses like wages, utilities and rent tend not to have future benefits. General repairs and maintenance of buildings are also considered operating expense, supposing improvements and additions aren’t being made which impact the efficiency or longevity of the asset.

Opex is important to consider as they accurately reflect the costs of doing business, since no future benefits are gained. If the Opex is too high, a company can easily lose money. Unlike Capex, the debt of which can be offset by future benefits, suffering debt to pay for Opex is always a problem.

A major difference between these two types of expenses is the way they are accounted for in an income statement. As Capex acquires assets that have a useful life beyond the tax year, these expenses can’t be fully deducted in the year they’re incurred. Instead, they’re capitalized and either amortized or depreciated over the life of the asset. Intangible assets such as intellectual property are amortized and tangible assets such as equipment are depreciated over their lifespan.

However, operating expenditure can be fully deducted. This means that Opex can be subtracted from the revenue when calculating the profit/loss of the organization. Most companies are taxed on the profit they make, so any expenses you deduct influences your tax bill.

In terms of income tax, organizations usually prefer Opex to Capex. For this reason, businesses will lease hardware from a vendor instead of buying it outright. Buying equipment is Capex so not all of the money paid upfront can be deducted. The amount paid to a vendor for leasing is Opex as it is incurred as part of the daily business operations. Therefore, the organization can deduct the cash that it spent that year.

Deducting expenses reduces income tax, which is levied on net income. It is also beneficial when considering the time value of money – money available at the present time is worth more than in the future due to its earning capacity.

However, if a company wants to boost its earnings and book value, it may decide to make a capital expense and only deduct a small portion of it as an expense. This will lead to a higher value of assets on its balance sheet, as well as a higher net income that it can report to investors. Or startups today want to convert CapEx requirement to OpEx requirement to reduce the huge capital requirement and fund the OpEx from revenues.

Below are the advantages of CapEx

  1. CapEx increases the earning capacity of a concern, for example a non-AC theater converted in air condition theater.
  2. CapEx will help the company to stand in the competition in the market.
  3. CapEx will make balance sheet healthier in financial terms and it attracts investors to invest more.
  4. CapEx will make company self sufficient, company does not  have to relay on others for example if company need to take on lease heavy equipment on regular basis and some time not readily available but own equipment are available at all the times.
  5. CapEx will help to get loan or facility from bank very easily by mortgage of assets created by CapEx.
  6. IN CapEx, many organisation are benefited from resale in properties on long term basis like building purchases and later sold on higher prices.

Below are the disadvantages of CapEx:

  1. CapEx needs very clear planning and budgeting if not then it may go in vain.
  2. CapEx may result in heavy interest charges if CapEx is through borrowed funds.
  3. Because of CapEx, the cash flow of the company gets disturbed to a great extent.
  4. If planning of CapEx is failed it will result in a sale of assets on lower prices resulting in heavy losses.
  5. If CapEx is from borrowed funds then a company’s balance sheet will not be a healthy one as the money invested in CapEx will be shown as a debt in the balance sheet.

In short, CAPEX is better suited for a longer-term investment that will not change over time and where you can afford the depreciation. OPEX is better suited for shorter-term investments that may need to change in the near future. A car is a great example of the CAPEX/OPEX argument. If you plan to keep the car for 10 years, it makes sense to buy the car (CAPEX) but, if you plan to change cars every few years, then a lease (OPEX) would be a less expensive option.

Is Depreciation an Operating Expense?

An operating expense is any expense incurred as part of normal business operations. Depreciation represents the periodic, scheduled conversion of a fixed asset into an expense as the asset is used during normal business operations. Since the asset is part of normal business operations, depreciation is considered an operating expense.

However, depreciation is one of the few expenses for which there is no associated outgoing cash flow. The reason is that cash was expended during the acquisition of the underlying fixed asset; there is no further need to expend cash as part of the depreciation process unless cash is expended to upgrade the asset. Thus, depreciation is a non-cash component of operating expenses (as is also the case with amortization).

If a business has a large fixed asset investment, this means that the non-cash depreciation portion of its operating expenses can greatly overstate the amount of month-to-month cash outflow actually being caused by company operations. Therefore, companies report depreciation as a separate line even though it is an operating expense to bring clarity on the operating expense which involves an actual cash outflow.

Hope this is useful, thank you!