Wednesday, October 26, 2016

Community Question - Understanding Capital Expenditures

Explaining capital expenditures, and how to book them     
A common theme I have been seeing is a request to explain how to book capital expenditures both by business owners and bankers. But before we dive too far in, lets answer the big question. What are capital expenditures?"

By definition, capital expenditure is the money your business spends on fixed (large) assets with fixed assets being anything from land, properties, equipment, vehicles, and so on. But from my experience, a lot of business owners run into trouble when they have to decide which equipment is capital expenditure versus an everyday expense. 

The confusion comes from having to scale the rule down to meet your business size. If we look at the rule for capital expenditure it appears straight forward and pretty clean cut (if you're a multi-million dollar company). However, look deeper and its apparent that it wasnt written for small to mid-size business owners. The everyday business owner isnt going to be in a position to buy a $1 mil building or a $70,000 piece of machinery. Those kinds of acquisitions are pretty black-and-white when it comes applying capital expenditure. But what do these grey areas look like for most small business owners? 
  • A dentist buys an x-ray machine during a liquidation sale for $500.
  • A freight company buys five used trucks for $2,000 apiece.
  • A carpenter buys $6,000 in small tools/equipment
  • A manufacturer rebuilds a motor for $6,000 so it can operate a machine worth $12,000

Right off the bat, we can see that these meet the qualifications for capital expenditures. It is the purchase of land, properties, and equipment. But how should you book these expenditures so your financials are accurate?

 A dentist buys an x-ray machine during a liquidation sale for $500.  

This meets the capital expenditure definition as it is a piece of equipment. However, it is a very small dollar amount and one has to ask, Is it worth holding onto the balance sheet to be depreciated? The standard accounting answer to this is probably not worth the extra effort to depreciate over the next 10 years."

So this is an example that, although it is a capital expenditure by definition it can easily be expensed on your Profit & Loss without too much of a second thought.

A freight company buys five used trucks for $2,000 apiece.

On the surface, this appears to be a situation that could also be expensed on the Profit & Loss just like the dentist example. It is only $2,000 where a new truck would normally run around $25,000. But there is a catch on this one the company bought five trucks. This brings the total purchase to $10,000.

In this scenario, the truck acquisition should definitely go onto the Balance Sheet under Fixed Assets. The reason being, those trucks have a useful life of several years and booking them onto your Profit & Loss would not only make a month look bad but it would also give an understated view of your financials. Which could be bad if you are going before a bank for lending purposes.

A carpenter buys $6,000 in small tools/equipment.

This scenario is a bit trickier, as it does not tell us what makes up the small tools/equipment.  This is where having an accountant is handy if these happen to be small power tools; then they definitely should be on your balance sheet as those also have a useful life.

However, if these happened to be screwdrivers, plugs, hammers, and such then it is debatable. The question then boils down to, how closely do we want to track these particular items? The last possible way for this to turn out is if these tools/equipment are perishable or be depleted.

If the answer is yes then they are definitely not fixed assets. But this is a situation where an accountant or Outsource CFO would be ideal. As it is up to them to make that judgment call and keep your financials consistent with the decision.
(To those accounting savvy people out there if it is perishable/becomes depleted; it could be considered inventory. So, A+ if you knew that.)

A manufacturer rebuilds a motor for $6,000 so it can operate a machine worth $12,000.

This one is definitely a capital expenditure but not because it is a piece of equipment but, more due to accounting regulation. When it comes to fixed assets and depreciation, the IRS recognizes that if you spend enough money on a piece of equipment; it can be considered a new capital expenditure.

So in this situation, you have already bought the machine and booked it on your balance sheet as a fixed asset. During the time that you have owned this machine, the motor broke and you had to spend an additional $6,000 to fix the motor.

That $6,000 makes the motor a new piece of equipment because the IRS states that any repairs done to a fixed asset that exceeds 50% of its current worth, is considered a new capital expenditure. Thus, in this case, you should add $6,000 to your fixed assets on your balance sheet.

Lastly, while few business owners find themselves in this situation it definitely pays to have an accountant who can interpret the regulations to your benefit. Otherwise, the $6,000 can easily find its way onto your Profit & Loss and ruin an otherwise good month or even hamper your borrowing ability.

To conclude this, capital expenditure is definitely something all business owners have to contend with at some point in their career and it pays to have an accountant help you through these moments. An incorrect booking of capital expenditure can lead to inaccurate financials, however, it can also lead to an inability to borrow from a bank which can make all the difference for a small business.

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