CAPEX vs. Current Expenses: An Overview
Current expenses are the necessary purchases that keep a business going from day-to-day, such as rent, utility bills, and office supplies. Meanwhile, capital expenditures, or CAPEX, are considered asset purchases, or long-term investments made into a business rather than general business expenses. The Internal Revenue Service (IRS) allows companies to reduce their taxable income by deducting certain costs or expenses each year. However, current expenses and capital expenditures are reported and accounted for differently.
- Current expenses are the necessary purchases that keep a business running such as rent, utility bills, and office supplies.
- Capital expenditures are asset purchases that have a useful life of longer than one year and are considered long-term investments in a business.
- Current expenses are expensed in year one, reducing a company's taxable income.
- With CAPEX, the asset's cost is spread out over several years, and the portion that is expensed reduces taxable income.
Capital expenditures, or CAPEX for short, represent the amount of purchases of long-term assets that a company made within a period. Typically, CAPEX spending by a company is done for the purchase of fixed assets, such as property, plant, and equipment. Fixed assets are the physical assets that a company needs to keep their business operating.
Examples of capital expenditures include:
- Technology, such as computers
- Property including real estate
- Equipment, such as manufacturing equipment or machinery
If a company is engaged in capital expenditures, it can signal that the company's management team believes that there are positive signs that sales and revenue will grow in the future. Investors like to see companies invest in their future. The level of CAPEX spending of one company versus a competitor can provide insight to investors as to how well a company is managed. Conversely, if a company's ownership fails to upgrade their equipment and does not purchase new technologies, their equipment might become obsolete, resulting in the company falling behind their competitors in the long term. For an item to be considered a capital expenditure, the asset must have a useful life of more than one year.
Current expenses are short-term purchases, or those used for less than one year, with no long-term effect on the profitability of a business. Examples of current expenses include:
- Office Supplies
- Computer toner and paper
- Vehicle expense, such as fuel
Current expenses do not involve major asset purchases, but instead, are the day-to-day expenses necessary to keep a company operational.
Current expenses and CAPEX both reduce profit and taxable income. However, current expenses reduce taxable income in year one while CAPEX is spread out over several years.
Key Differences: Accounting Treatment
Companies can treat their expenses or costs as either current or capital. The difference between the two treatments will result in whether the cost is expensed in year one or whether the cost is spread out over several years.
Current expenses are fully tax-deductible in the year in which they are incurred. In other words, the tax deduction reduces the income of the company by the amount of total current expenses. As a result, the company pays less in income tax for the year since they would report a lower income amount for tax purposes. The IRS allows companies to deduct certain expenses used for business operations.
Because CAPEX is treated as an investment, the tax deduction is treated differently than current expenses. The IRS does not usually allow companies to deduct the total amount of an asset's cost in the year in which the cost was incurred. Instead, beginning in the year following the purchase, the costs for the long-term asset are deducted over the course of several years or capitalized.
The long-term asset is recorded on the balance sheet at its historical cost, which is usually the purchase price. A portion of the asset's value is carried over to the income statement each year and recorded as an expense–a process known as depreciation. The depreciation expense decreases profit each year until the useful life of the asset has expired, and the asset's cost is fully recovered.
Since the asset generates revenue each year, deducting the costs of the asset over several years, helps a company more accurately reflect the profitability of the business. Also, capitalizing an asset can smooth out a company's earnings or profit by reducing wild fluctuations in earnings in years in which long-term fixed assets are purchased. Since depreciation expense reduces profit, it also reduces a company's taxable income.
Improvements vs. Repairs
The IRS has strict guidelines for how CAPEX should be treated. For example, repairs are considered current expenses, but improvements are capital expenses. If repairs were done to fix a leaky roof, the cost of the repairs could be deducted from the current year's taxes as a repair. However, if the roof was replaced, the cost would be considered an improvement and as a result, must be deducted over several years.
Sometimes it can be challenging to know when to deduct a repair or improvement as an expense or treat it as a capitalized asset. A repair shouldn't add significant value to the asset and therefore; should be expensed. An improvement should be treated as a capitalized asset if the improvement increased the asset's value, extended its useful life, or created a new use for the asset.