Pay now, use for years

Pay now, expense later

Morrow pays $12,000 for a wheel-building machine it expects to use for four years. The cash left the bank on Tuesday. Whether Tuesday's Scorecard (income statement) shows a $12,000 cost, a $3,000 cost, or nothing at all depends on one decision: capitalize or expense?

Capital expenditure buys an asset that pays off beyond this period. An expense is a cost used up in producing this period's results. Paying cash decides neither; the cash clock shows $12,000 out either way. Management calling the project "strategic" decides nothing either. This is a Snapshot (balance sheet) question first, because a capitalized cost becomes an asset, and a Scorecard question second, because that asset turns into expense over the years it is used. The reflex is which clock.

A routine repair that keeps the machine running normally is expensed. A major improvement that adds capacity or extends its life is capitalized. The rules decide, not the size of the invoice.

The cost of the asset is more than the invoice. Delivery, installation and testing are part of the machine's cost, because the machine is not ready for use without them. Training the mechanics to use it is expensed. For an asset a business builds for itself over many months, US GAAP adds the interest on money borrowed during construction to the cost, and IFRS does the same.

Worked example: the first year, two ways

Assume no residual value and use from the start of year one. Capitalized, the machine costs the Scorecard $3,000 a year for four years: 12,000 ÷ 4. Expensed, it costs the Scorecard $12,000 in year one and nothing after. Cash out is $12,000 on Tuesday in both cases.

Same cash, two first-year profits $9,000 apart. That gap creates incentives. Aggressive capitalization makes current profit look stronger and parks cost on the Snapshot for later depreciation, or a later impairment. An analyst reads the capitalization policy, the additions each year, the useful lives, and whether spending is followed by the operating benefits it was supposed to buy.