Capital Accounts and Expense Accounts

Capital Accounts and Expense Accounts

The money used to pay for different types of work can be classified separately from an accounting standpoint, and this distinction may in turn drive some of the decisions that are made in terms of overall portfolio balance.

The most obvious is the classification of some spending as “capital” and some as “expense”.

These categories of expenditures have a strict accounting meaning, although different companies might put slightly different interpretations on the meaning.

Work (and other purchases) that has short-term value is typically considered an “expense” item from an accounting standpoint.

The costs associated with this expense work are deducted from revenue in the year in which the expense occurs.

On the other hand, work that creates deliverables with a useful life of over one-to-three years can be considered “capital” spending.

The cost of capital spending can be depreciated over some period of time, usually three or five years.

In other words, if you spend $120,000 on a capital project with a lifespan of three years, you would deduct expenses of $40,000 per year for three years, rather than deduct the entire $120,000 expense in one year.

Many companies try to balance the total amount of capital spending each year as opposed to the total expense spending. Companies then control how they are reporting overall company expenses, which help them manage their profit numbers (revenue minus expenses).

The key to this type of balancing is that you cannot determine whether to capitalize or expense certain types of work at the end of the year. The rules for how you determine which expenses can be capitalized are known well ahead of time.

However, if your company has targets as to how much work they want to capitalize versus expensing in the same year, these targets can be used to determine the type of work you want to take on in the first place.

This is where you can balance the portfolio spending to stay within your corporate guidelines for capital spending versus expense spending. Using this balancing model, for instance, you may decide not to do a very attractive project this year because it is a capital project, and you may not have any more capital funding left. You may need to choose expense projects instead.

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