CAPITAL EXPENDITURE BUDGETING

CAPITAL EXPENDITURE BUDGETING FM A – M ANAG EM ENT AC C OUNTI NG

LEARNING OUTCOMES 1. Discuss the importance of capital investment planning and control 2. Define and distinguish between capital and revenue expenditure 3. Outline the issues to consider and the steps involved in the preparation of a capital expenditure budget

INTRODUCTION • Long term investments – Include purcahse of buildings, machineries and equipment. Management must make estimates of the initial investments and future costs and revenues of a project to make long term decisions • Include looking at options available when a company puts many into an investment • When a company puts money into a project, it will expect some sort of financial return at some point in the future

• Time value of money will be considered • The thinking is “If I have $8 in my pocket now, how much will this money be fourth in five years time?”

CAPITAL EXPENDITURE & REVENUE EXPENDITURE • A capital expenditure is an amount spent to acquire or improve a long term asset such as equipment or buildings. Usually the cost is recorded in an account classified as property, plant and equipment. The cost (except for the cost of land) will then be charged to depreciation expense over the useful life of the asset.

A revenue expenditure is an amount that is expensed immediately—thereby being matched with revenues of the current accounting period. Routine repairs are revenue expenditures because they are charged directly to an account such as Repairs and Maintenance Expense.

Even significant repairs that do not extend the life of the asset or do not improve the asset (the repairs merely return the asset back to its previous condition) are revenue expenditures.

CAPITAL EXPENDITURE • Capital expenditure includes costs incurred on the acquisition of a fixed asset and any subsequent expenditure that increases the earning capacity of an existing fixed asset.

• The cost of acquisition not only includes the cost of purchases but also any additional costs incurred in bringing the fixed asset into its present location and condition (e.g. delivery costs).

• Capital expenditure, as opposed to revenue expenditure, is generally of a one-off kind and its benefit is derived over several accounting periods. Capital Expenditure may include the following: – – – – – –

Purchase costs (less any discount received) Delivery costs Legal charges Installation costs Up gradation costs Replacement costs

Thus, Dr Fixed Assets

Cr. Cash / Payables

REVENUE EXPENDITURE • Revenue expenditure incurred on fixed assets include costs that are aimed at 'maintaining' rather than enhancing the earning capacity of the assets.

• These are costs that are incurred on a regular basis and the benefit from these costs is obtained over a relatively short period of time. Revenue costs therefore comprise of the following: – Repair costs – Maintenance charges – Repainting costs – Renewal expenses

• As revenue costs do not form part of the fixed asset cost, they are expensed in the income statement in the period in which they are incurred. The accounting entry to record revenue expenditure is therefore as follows: Dr. Revenue Expense (I/S) Cr. Cash/Payables

CAPITAL INCOME & REVENUE INCOME • Capital income – proceeds from the sale of non trading assets (i.e. proceeds frm the sale of NCA, including NCA investments).

The P/L from the sales of the NCAs are included in the income statement of a business, for the accounting period in which the sale takes place • Revenue income is derived from the following sources – The sale of trading assets – Interest and dividends received from investments held by the business

PREPARING CAPITAL EXPENDITURE BUDGETS • The capital expenditure budget is essentially a non current assets purchase budget and it will form part of the longer term plan of a business enterprise.

• Sales, production and related budgets cover, in general, a 12 month period.

• A detailed capital expenditure budget should be prepared for the budget period but additional budgets should be drawn for both the medium and long term • This requires in depth of the organization’s requirements for lands, buildings, plant and machinery, vehicles, fixtures and fittings and so on • Suitable financing must be arranged as necessary • Some forms of capital expenditure may be budgeted for by means of a set “annual allowance” for the purchase and replacement of NCAs