Every purchase a company makes represents either an expense or an asset. Expenses, like supplies, rent and utilities are purchases that are quickly used up. Assets meanwhile add value to the business and have an economic life of at least a year. Capital expenditures are assets that a company must depreciate over the economic life of the asset. Types of a capital expenditure can include purchases of buildings and machinery.
Capital expenditures are purchases made to acquire or improve a fixed asset. According to generally accepted accounting principles (GAAP), a fixed asset is a physical asset the company expects to hold for more than a year. Such capital expenditure examples include buildings, equipment, software or machinery. A purchase represents a capital expenditure whether the company purchases the item from someone else or constructs the asset itself.
Any money spent on the asset going forward is a capital expenditure if it lengthens the economic life of the asset or increases the asset's value. For example, adding solar panels to the building is a capital expenditure; replacing broken windows with windows of the same quality is not.
Rather than being expensed immediately, capital expenditures are capitalized as an asset and depreciated. For example, say a company spends $50,000 to purchase a building. The accountant would debit a building asset account for $50,000 and credit cash for $50,000. When the company generates the financial statements, the balance sheet will show a $50,000 fixed asset.
Because the transaction was classified as an asset purchase rather than an expense, the purchase will not appear on the expense portion of the income statement.
Under capital expenditure accounting, the company records expense for capital expenditures by identifying the life of the asset and the asset salvage value, and assigning depreciation expense each year. One of the most common depreciation methods used in GAAP is the straight line method. With this method, the company books an equal amount of depreciation expense each year.
For example, if the $50,000 building has an economic life of 10 years and no estimated salvage value, the company would record $5,000 of depreciation expense each year. Meanwhile, if there was a $10,000 associated salvage value — the value of the capital after its economic life is up — you would depreciate only $40,000 over the ten years, or $4,000 of depreciation expense each year.
The company records depreciation on the capital expenditure by debiting depreciation expense and crediting accumulated depreciation. The accumulated depreciation reduces the value of capital expenditures on the balance sheet.
For example, if the asset was purchased at $50,000 and accumulated depreciation is currently $5,000, the value on the balance sheet will be $45,000. If the company makes $6,000 worth of improvements to the building, the net value would be $51,000 ($50,000 original price plus $6,000 in improvements less $5,000 accumulated depreciation).