2 Classify Capital Cost Transcript

Series: Capital Investments How to Classify Capital Project Costs Transcript

Table of Contents Introduction ...... 2 The Difference Between a Capital Asset and a Capital-Related Expense ...... 2 The Major Elements of the Capitalization Policy ...... 4 Summary ...... 5

Introduction As part of the request for a capital investment project, a manager often faces the difficult task of identifying and classifying the different types of project costs based on the company’s capitalization policy. In this module, we will describe the difference between a capital asset and a capital-related expense and explain how these expenditures are reported on the financial statements. We will also learn to identify project costs as either capital assets or capital- related expenses. Finally, we will discuss the major elements of a company's capitalization policy and its importance for you as a manager.

The Difference Between a Capital Asset and a Capital-Related Expense As discussed in the first module of this series, An Introduction to Capital Investments, a capital investment can be any long-term project that involves a significant outlay of funds and is expected to yield benefits over time. These expenditures, which represent the costs incurred to complete a project, are classified either as capital assets or capital-related expenses during the capital investment process. Generally accepted accounting principles require that the cost of assets whose benefits extend over a period of time be charged against future income. Therefore, the proper classification of project costs affects the accuracy of the financial statements. A capital asset is any expenditure incurred in the acquisition or improvement of a tangible, long-lived asset that will provide benefits over one or more years beyond the acquisition period. The acquisition period is defined as the period commencing with the first expenditure for a qualifying asset and ending when the asset is substantially completed and ready for its intended use. Capital assets typically include the purchase of land, buildings, furniture and fixtures, machinery and equipment, and vehicles, among others. They may also include improvements on existing assets such as equipment add-ons or upgrades, and building and leasehold improvements. Capital assets are used for the operations of the business, have relatively long useful lives, and are reported as fixed assets on the balance sheet. The cost of the capital asset usually includes the purchase price of the item and all other costs incurred to make the asset ready for use. These costs may include freight, duties, insurance, sales tax, installation charges, and brokerage fees, among others. As mentioned previously, generally accepted accounting principles require accountants to charge the cost of an asset over the time period in which they expect to receive the corresponding benefits. The systematic accounting method used for this purpose is called depreciation. We encourage

© 2016 OBA How to Classify Capital Project Costs Page 3 you to view our module The Fundamentals of Depreciation for a more detailed explanation of this concept. A capital-related expense is any expenditure incurred in the acquisition of a capital asset that does not add utility or functionality to the asset and does not provide any future benefit to the organization. These costs are usually ordinary and necessary expenditures to maintain an asset in efficient operating conditions and do not add value or prolong the life of the asset. They are expensed to the income statement when incurred. Some examples of these expenses may include maintenance contracts, operating supplies, and spare parts. Managers often do not include capital-related expenses in a capital appropriation request because it is generally not required by company policy. However, it is important identify all costs in a capital project, regardless of whether they will be classified as assets or expenses. The omission of capital- related expenses underestimates the true cost of the project and may overestimate the return on investment. In the transcript of this video, we have included Figure 1, which summarizes the major differences between capital assets and capital-related expenses. Figure 1. A Comparison of Capital Assets and Capital-related Expenses

Category Capital Assets Capital-related Expenses

• Expenditures incurred in • Expenditures that do not the acquisition or add to the utility or improvement of tangible, functionality of the asset. Classification long-lived assets. • Ordinary and necessary Criteria • For use in the business expenditures to maintain operations. an asset in efficient • Have relatively long operating conditions. useful lives.

• Reported on the balance • Reported on the income sheet. statement. Accounting • At cost or fair market • Charged as an expense in Treatment value (FMV). the period incurred. • Asset depreciated over its useful life.

While project cost classification for new assets is generally straightforward, projects that involve the improvement of an existing asset often present a real challenge. According to accounting rules, an improvement to an existing asset can be capitalized if the investment increases the capacity of the asset; increases the operating efficiency of the process; extends the useful life of the asset; or changes its original functionality. If the improvement merely helps maintain the efficient operating condition of the asset, these costs should be expensed. Expenditures for improving existing assets should be significant in order to qualify for capitalization. Minor expenditures are typically expensed. In your additional materials, we have included a handout that shows common project costs and their recommended classification.

The Major Elements of the Capitalization Policy While accounting principles provide general guidelines in terms of the capitalization of fixed assets, medium to large companies typically have a formal capitalization policy. Small businesses may not have a formal capitalization policy and simply follow tax guidelines in determining how to capitalize their assets. The capitalization policy generally provides comprehensive guidelines for the accounting treatment of fixed assets. It describes what types of assets should be capitalized, when to capitalize these assets, and how they should be capitalized. Figure 2 shows an example of a typical capitalization policy of a large corporation. This example, which is included in the transcript of this video, explains when a manager should capitalize an asset purchase. However, the capitalization policy of a company is usually more extensive providing additional information to ensure that the asset is properly classified and recorded on the books. This information may include the balance sheet account where the asset will be reported, the estimated useful life, and the depreciation method to use for a particular category of assets. Knowledge of your company's capitalization policy ensures project costs are properly accounted for and recorded in a consistent manner.

Figure 2. Capitalization Policy Example

The purchase of an asset is considered a capital expenditure when the item costs at least $1,500 and has a useful life of at least one year. Items costing less than $1,500 are treated as capital assets if their useful life is at least one year and they are part of: a) a number of items forming a larger unit whose total value is greater than $1,500; or b) a number of items of a permanent nature whose total aggregate value is greater than $1,500, for example a group of desk chairs or printers. An item that routinely falls in this category will be treated as a fixed asset even though only one is bought at a time.

Summary In summary, project costs are classified as either capital assets or capital- related expenses. A capital asset is any expenditure incurred in the acquisition or improvement of a tangible, long-lived asset that will provide benefits over one or more years beyond the acquisition period. It is reported on the balance sheet. A capital-related expense is any expenditure incurred in the acquisition of a capital asset that does not add utility or functionality to the asset and does not provide any future benefit to the organization. It is reported on the income statement. It is important to ensure that all costs in a capital project are identified, regardless of whether they will be classified as assets or expenses. The omission of any expenditure, capital or expense, underestimates the true cost of the project and may overestimate the return on investment. A review of your company's capitalization policy will allow you to properly classify project expenditures. When in doubt, contact your fixed asset accountant or financial liaison. This concludes our presentation on how to classify capital project costs. We encourage you to visit our web site for more information and additional learning resources.