Capital Expenditure: Capex - Essay Example

?Finance and Accounting What capital expenditure is means? Capital expenditure (Capex) is defined as the expenditure gained on the purchase or improvement or alteration of fixed assets (Henry and Piekarski, 2005). For example: purchase of a car used to deliver goods. Some costs which are included in the capital expenditure are the following: delivery of the fixed asset, improvement of fixed asset, legal costs of purchasing property and installation of fixed assets (Porter, 2011). Capex is shown in the balance sheet. It is very important to categorize this expenditure without any mistake in the accounting system because miscalculations will lead to the asset and liability mismatch (Albrecht, 2011). Acquiring fixed assets like building, land, plant and machinery, motor vehicle and furniture fittings are regarded as the capital expenditure. The assets are not to be sold for making profit but that assets should be retained in the business. Capex generally yields gains over a long period of time (Banerjee, 2010). Capex on a financial statement is important as the investors are interested in the amount of capital improvement that he experiences. The declining capex will make the investor cautious as well as abnormal increased values signals that the investor should also be cautious (Jennings, 2006). The different types of capex are the following: Expenditure resulting from the acquisition of permanent assets: Any asset that can be converted into cash later. The money spent to acquire the asset is called capex (Warren, 2009). Expenditure resulting from purchase, erection or receipt of a fixed asset: The expenses in addition to the purchase price that are incurred for manufacturing the asset for use are added to the cost of the asset and thus is regarded as capex. The examples are the wages that are paid to the workers for manufacturing machines, the cost of the place where the machine will be manufactured and the interest on the loan raised to purchase a fixed asset. Expenditure resulting from improvement of the fixed asset: If the profit earning capacity increases because of the expenditure, through lowering of cost or increase the output level, it is capital expenditure. Expenditure incurred to get the right to carry on business: The expenses that are needed for establishing a business or acquiring license is capital expenditure. The cost of patent is also capital expenditure. Expenditure resulting from acquisition of tangible asset: The expenditure incurred on a non profitable asset is treated as capital expenditure. Factors that add to the cost of capital expenditure (with examples) Cost of capital expenditure i.e., the interest payments and the cash-flow, that affect cash that are available in the capital goods. Example: If one borrows ? 10000 to buy a new coffee maker and it brings with it an additional ?1000 / month of profit but the monthly interest that are to be paid for the loan is ?1120, then it is said to be the bad expenditure with a negative impact on the business. Now if the same person borrows the same amount but bring ?1500 profit/month it is a good investment. Thus, there are different factors that add up to the cost of capital expenditure and can make an investment unprofitable and even profitable. How does capital expenditure lose value over time? A product when capitalized the value of the item is placed in an asset that increases the total value of the company. The reason behind these is that the items are considered to lose their value slowly or increase over time. The asset is listed on the company’s property tax inventory and the asset is provided a number for tracking purposes (Elmaleh, 2005). The company gets bill for taxes on the value of the assets and the listing of an asset that is depreciating decreases in value each year until it is considered to have no value (Hoofman, 2009). After capitalizing, the item is allowed to depreciate over a period of time, such as 3 – 5 years of time. After depreciation the entire cost of the item is not revealed in the expenses at one time, but is divided over several years (Grant, 2001). The time period for depreciating an item is based on how long the item will sustain. Properties like land and building are depreciated out over a larger period of time whereas; items like vehicles depreciate over a period of 3-5 years which depends on the cost of the item. Describe two methods of accounting for the loss in value of capital expenditure items. The two methods of accounting for the loss in value of capital expenditure are the straight line method of depreciation and the reducing or diminishing balance method of depreciation (Harrison, 2008). Straight line depreciation method is method in which the depreciation is charged evenly over the life of the asset. The left value is subtracted from its cost to arrive at the depreciable amount. Depreciable amount is divided by the actual life of the asset, within which it can be used, to get the depreciation over a period of time. This is the most commonly used method because it is the simplest method of depreciation (Francis, 2010). The formula which can be used to calculate the depreciation in the straight-line method is: Depreciation = (Cost – Salvage Value) / Life in number of periods Advantages of the method: 1. It offers simplicity and thus easy to calculate. 2. The profit for the next year can be calculated very easily as the amount stays the same. This allows making financial forecast for several years. 3. The benefit for even depreciation is enjoyed over the life of the asset. Disadvantages of the method: 1. The fact that assets lose value more quickly in their early years is not taken into account in this method. 2. A machine for example loses its efficiency in the later years and the machine is written off with the same amount years after years. This is not suitable for a machine whose efficiency is declining at a high rate. 3. It cannot be used to those machines which does not have any specified life time (Milad, 2009). Example: A machine has a useful life of 3 years and the cost of the asset is ?2,000. The residual value is ?500. So the annual depreciation = (2000-500) / 3 = ? 500. Thus straight line method is suitable where the economic benefits from the assets are expected to be drawn evenly during its useful life time. It is also appropriate for the situations where there is no reliable estimate can be made about the pattern of economic benefits over an asset’s useful life. Reducing or Diminishing Balance method of depreciation is the method of depreciation that involves in multiplying the asset carrying amount by the depreciation rate to arrive at the depreciation/annum. Here the carrying amount means the value of the asset after the depreciation has been deducted from the actual cost. The method is used when a non- current asset is highly competent in its earlier years of life. The asset does not break down much and the repairs are kept to its minimum. As the asset gets older, it is likely to become out of operation and it is sent for repairing (Ingram, 2007). Under this method a fixed percentage of the diminishing value so the asset is written off each year and thus the asset is reduced to its break-up value or scrap value. The annual charge of depreciation decreases from year to year (Narayananswamy, 2008). Advantages of the method: 1. Easy to understand and simple to implement. Depreciation is calculated on the opening amount of the asset. 2. It equalizes the annual burden on profit and loss account in respect of both depreciation and repairs. The amount goes on decreasing while the expense on repairs increases (Bebbigton, 2001.). 3. It is an accepted method for income tax purposes. 4. It matches the cost and the revenue of the business (Edwards, 2008). Disadvantages of the method: 1. The method charges huge amount of depreciation in the initial years. 2. The formula that can obtain rate of depreciation is applied only when there is left over value of the asset (Kimuda, 2008). Example: A motor vehicle is purchased at ?25,000. Purchase date is 1/10/2008. Depreciation method: reducing balance 40% p.a. Solution: The financial year is ending at 30 June 2009, so the vehicle is owned for nine months worth of depreciation. Depreciation = Cost of depreciation rate / 12 months * months of ownership = 25000 * 40% / 12 * 9 = 7500. The cost of the asset is 25000 and we can claim 7500 depreciation for the year ended at 20 June 2009. Now, Original cost – depreciation to date = carrying amount = 25000 – 7500 = 17500 Carrying amount * depreciation = depreciation expense = 17500 * 40% = 7000 Therefore, the depreciation expense is ? 7000. Reference List Albrecht, W., 2011. Financial accounting. New York: South-Western Cengage Learning. Banerjee, B., 2010. Financial accounting. Delhi: PHI Learning Private Limited. Bebbigton, J., 2001. Financial accounting. Singapore: British Library Cataloguing-in- Publication Data. Edwards, J., 2008. Financial accounting. New York: Routledge Elmaleh, M., 2005. Financial accounting. Union Bridge: Eplphany Communication. Francis, J., 2010. Financial accounting. New York: South-Western Cengage Learning. Grant, E., 2001. Depreciation. New Jersey: Ronald Press Company. Harrison, W., 2008. Financial accounting. London: Pearson Prentice Hall. Henry, C. and Piekarski, J., 2005. Techniques for capital expenditure analysis. New York: M Dekker. Hoofman, G., 2009. Financial accounting. Boston: Houghton Mifflin Company. Ingram, R., 2007. Financial accounting. New York: South-Western Cengage Learning. Jennings, R., 2006. Financial accounting. Singapore: British Library Cataloguing-in- Publication Data. Kimuda, D., 2008. Financial accounting. Kampala: East African Publishers ltd. Milad, A., 2009. Financial accounting. Bloomington: AuthorHouse. Narayananswamy, R., 2008. Financial accounting. Delhi: PHI Learning Private Limited. Porter, G., 2011. Financial accounting. New York: South-Western Cengage Learning. Warren, C., 2009. Financial accounting. New York: South-Western Cengage Learning. Read More