Capital VS Expense
Friday, January 22, 2016
Capital VS Expense
When do you capitalize an item? We come across this question often. There are specific requirements a purchase must meet in order to be capitalized:
Expenses happen often in a period or recur each period. Fuel, new tires, small tools, etc. are examples of expenses that happen often and are not capitalized. These expenses are matched with the current revenues. The only time that repairs are capitalized is if the repair/or maintenance extends the useful life of the item and is considered an improvement of the asset. New tires extend the life of the vehicle but are not considered an improvement over the previous tires on the vehicle so they are expensed. However a new tool that cost $600 is capitalized assuming its life extends beyond 1 year.
A capitalized item is called a fixed asset. Fixed assets are amortized (or depreciated) over their estimated “life” i.e. how long it is expected to last. A computer is amortized faster than a truck as the computer is not expected to last as long due to technology changes.
Often, for convenience and consistency with the tax return, the amortization expense is calculated at the same rate as provided by the Canadian Tax Act. The amortization rate for a truck (a self-propelled asset) is 30% whereas a tool (a stationary asset) is 20%. For more amortization rates see the following link:
There are various methods to calculate amortization. Two of the most common amortization methods are a straight line basis or a declining balance basis. The straight line amortization basis expenses the same amount every year whereas the declining balance basis expenses more when the asset is new and less when the asset is older. The theory is that there will be more repairs when the asset is older so to “smooth expenses” the amortization should be lower when the asset is older. That way, the total expense is more consistent. Again, for convenience and consistency with the tax return, the declining balance basis is often used as that is the method that the Canadian Tax Act requires.
The following is an example of how to calculate declining balance amortization.
As you can see, capitalizing and amortizing makes a large difference in a company’s year to year income statement. If you have more questions we would love to help so call us at 403-527-8114