watering can pouring on stacks of coins representing business growth

What Is a Capital Expenditure and What Are the Tax Implications?

Capital expenses are large purchases required to keep a business growing. Here’s what you need to know about these costs, including the tax implications. 

Key takeaways:

  • Capital expenditures are long-term investments like technology upgrades or significant equipment purchases
  • These purchases are recorded on the balance sheet since they’re investments, not everyday operational costs
  • Capital expenditures are not directly taxable, but depreciation can be deducted each year over the asset’s useful life
  • Tracking these purchases helps a business understand returns on investment and how they relate to business growth

Part of running a business is taking all the right steps to record financial transactions and keep track of cash flow, tax impacts, and ROI. Some aspects of bookkeeping will be straightforward, like tracking the everyday costs of running the business. In contrast, others can be more complicated, like major equipment purchases that are investments into future growth.

This guide will walk you through what capital expenditures are and how they work when maintaining financial records and paying taxes.

What are capital expenditures?

Capital expenditures include the purchases made by a business on long-term physical assets and property that improve capacity or efficiency. These assets could be real estate, equipment, machinery, technology, and the like. In accounting, an expense is considered a capital expenditure if its life is more than one accounting period (one year) or if the asset improves upon an existing asset, like an efficiency upgrade to a building, for example. 

These expenditures are usually made for business projects or investments that support the business so that it can continue its operations, improve the way it delivers services, or continue growing its revenue. Generally, capital expenditures are costs to maintain a business’s operations or expenses that lead to future growth.

Sometimes capital expenditures need to be made on a fixed asset, which may include upgrading a machine or improving something about the business’s property. These payments are more like investments instead of regular expenditures. In other words, capital expenditures are expenses that the company capitalizes, whereas operating expenses are short-term costs that support day-to-day operations.

Note that expenses associated with normal, everyday repairs and maintenance on assets are usually not considered capital expenditures.

How are capital expenditures recorded?

To fully understand capital expenditures, you also need to learn how to record them on your financial documents. Best practice states that if a piece of equipment or other asset has a useful life for under a year, it’s expensed on the income statement and is not considered a capital expenditure. A true capital expenditure is recorded on the balance sheet and is regarded as an investment, something that leads to long-term business health and growth. 

After a large asset is purchased and incorporated into your workflows, it will depreciate for the rest of its life. Depreciation expenses are recorded on the income statement.

Capital expenditures and taxes

Unlike operational expenses, capital expenditures usually aren’t fully tax-deductible in the year the purchase was made. Instead, the depreciation they experience can be deducted over the life of an asset.

For example, if you purchase business equipment that costs $500,000 and will last five years, you may be able to deduct $100,000 in depreciation each year of its useful life. Like other business deductions, depreciation can reduce a business’s tax burden significantly. 

There are exceptions to this rule, however. For example, IRS Section 179 allows businesses to fully deduct the expense of some qualifying capital expenditures in the year they are purchased.

Why are capital expenditures important?

Businesses record financial information for a variety of purposes, from forecasting to presenting to investors to assessing current profits. Keeping track of capital expenditures also has a vital role in the overall financial health of a company. These purchases usually have significant impacts on the organization’s future and can also affect current cash flow, as they are expensive. While they require large upfront expenditures, they are meant to have long-term benefits and payoff.

Capital expenditures are notably crucial for businesses in industries like telecom and manufacturing. These types of organizations usually put a lot more investment into expensive equipment to see bigger payoffs. But a variety of small businesses also routinely make significant purchases that qualify.

Recording these payments helps a business track how much it is investing in improvements or new assets linked to growth.

Capital expenditure challenges to be aware of

The process of recording this kind of spending and correctly forecasting its impact on the business isn’t always as straightforward as you might like. These expenses are larger and often more complex than other costs. Thus, the accounting process surrounding capital expenditures takes a bit more effort and planning.

Another challenge is accurately predicting investment outcomes. While any capital investment should bring financial benefits, sometimes losses are incurred when unforeseen circumstances arise, whether something goes wrong with an asset or a problem arises that’s unrelated to the expense but impacts its use nonetheless. There is always at least a little uncertainty about the future when making capital expenditures, and all businesses can do is project the impact and outcome to justify the purchase.

Provident CPA and Business Advisors can help

Our team of experts helps businesses like yours get on the right track for long-term success. We can help you understand best practices for accounting and business planning so that you have the visibility and knowledge necessary to succeed.

Contact our team of business strategy and accounting professionals today to get on top of capital expenditure reporting and your business’s tax obligations.

0 replies

Leave a Reply

Want to join the discussion?
Feel free to contribute!

Leave a Reply

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.