Determining the Difference Between Capital and Expense Expenditures
Before jumping ahead and finalizing those business plans you’ve been dreaming about, don’t forget to take a step back and remind yourself about the various parts that lead up to its final creation. We’ll focus on one of everyone’s favorite topics, the financial side. 😉
One important facet of putting together a business plan is determining how certain purchases play into the budgeting and reporting of the business income and ultimately reporting the business income to the IRS. When making the decision to purchase something it is necessary to choose between whether the expenditure should be treated as a capital expenditure or an expense item. It is important to look at both options in order to distinguish the difference.
Let’s start with treating the purchase as an expense. Generally, expense items are recurring, regular, and repeated. The decision to treat the expenditure as an expense item will typically involve the following question: Is the useful life of the item greater than one year. If the answer is no then the item is usually expensed. Typical expense items in a business include supplies, repair and maintenance, and meals and entertainment. And as an expense, the business receives benefits within the accounting year instead of over a period of years. Unlike expenses, capital expenditures have an economic benefit to the company over several years. Items such as equipment, buildings and vehicles are typical capital expenditure items. With capital expenditures the answer is yes to the “benefit longer than one year?” question.
Capital expenditures are then “depreciated” over the estimated useful like of the item. Depreciation is just accountant jargon for expensed. Equipment could be five years and buildings 39. Another common item for many businesses to capitalize is inventory. While one item in inventory may not have a large value, a significant quantity of items are usually purchased and consumed over a longer period of time. If the consumption of these items is likely to stretch into the next year, then the items are typically put into inventory and expensed as they are consumed.
As you can see from the above discussion, whether or not a purchase is an expense or a capital expenditure can be a decision that can have a significant impact on your business’ financial results. Making the right decision not only will determine the appropriate accounting, but will also impact your business’ net income and what gets reported to the IRS.
If you are undecided as to which way your item should be treated, consult with your accountant or tax advisor. Or contact us here at O|Miga. We’ll be happy to talk it over with you. Best of luck with growing your business!