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Oct
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Reporting on Capital Expenditures . . . or . . . Budgeting Fixed Assets

Last week I was having an interesting conversation with a friend in our budget and analysis department. We were discussing the best way to budget and report on capital purchases. I realized that we can’t be the only accountant and financial analyst to struggle with the best way to treat fixed assets. I also expect many of you have mastered this years ago; but I’m sharing the basics of our conversation here in the hope that some of you also find it useful or interesting.

 
The concept of capitalizing fixed assets and recording regular depreciation is well established in GAAP accounting. Most accountants can flash back to their first accounting professor using equipment to demonstrate the matching principle. Likewise we would all have some explaining to do to our auditors if we told them we didn’t capitalize fixed assets. GAAP reporting is understood (at least by accountants) . . . so I’m setting it aside for this conversation.

 
The conversation gets more interesting when we talk about how an organization chooses to budget and report on fixed assets internally. My conversation contrasted two methods of planning and reporting on fixed assets for management purposes. The first is to mirror GAAP accounting when budgeting. Under this approach fixed assets are tracked by department, and budget managers see ongoing depreciation expense in their monthly reporting. The second method is to expense all fixed assets at time of purchase (for budget and internal reporting purposes). Department managers would budget the full amount of the initial purchase, but would not consider ongoing depreciation.

 
Let’s explore this capital expenditure method a little more. I like this method because it is simple and easy for non-finance managers to understand. Shocking as it is to my little accounting soul, it turns out that not every manager would automatically think to budget depreciation for the next five years after purchasing a new copier. The capital expenditure method allows managers to budget as money is spent. This brings me to the next advantage. Generally the capital expenditure method follows cash flow. This is how most people think when budgeting.

 
Not surprisingly, what is easy for non-accountants requires some extra work from the finance side of the house. In case you were wondering how this method is compliant with GAAP reporting, here is how it works: When a fixed asset is purchased, it is booked as debit to a capital expenditure account and to the purchasing manager’s department/cost center (Debit expense, Credit Cash). At least once a month all activity in the capital expenditure account is credited, using a non-reporting department/cost center. The offsetting debit goes to fixed assets (Debit fixed asset, credit expense). Accounting tracks and records depreciation expense as usual, recording the expense to the same non-reporting department/cost center. We call this department “accounting use only” and both the budget and accounting teams know that its sole purpose is to re-class capital expenditures to the balance sheet and record depreciation.

 
The “mirror GAAP” method of budgeting for fixed assets also has some advantages. We already discussed how this method has straight forward accounting. In addition mirroring GAAP highlights capital assets and their long term nature to budget managers because depreciation expense continues to impact their budgets and reports for years after an initial purchase. For this reason this approach works well in organizations that have developed a robust capital budgeting program, to track, prioritize, approve, fund, and monitor long term investments in the business.

 
I see two potential disadvantages to the GAAP style approach to budgeting for fixed assets. The first is that expense trails cash flow. This can lead to liquidity challenges. Now liquidity can certainly be tracked (and arguably should be tracked) and managed independently of the budget and reporting of expenses. However, human nature often seeks to pay for today’s purchases with future budgets. (Examples include J. Wellington Wimpy – “I’ll gladly pay you Tuesday for a hamburger today” . . . and the national debt of every democracy I’m familiar with). Therefore, caution should be exercised to make sure that the organization has revenue or reserves to cash flow expenditures which will be charged against future budgets.

 
The second potential disadvantage is that if managers’ budgets continue to be impacted by ongoing depreciation, this may lead them to make future decisions based on sunk costs. Although, as I think about it further, it is probably unfair to bring this into the conversation. After all if your managers make decisions based on sunk costs, the fault is probably with the managers, and not the reporting model.

 
Both models can be appropriate for different organizations at different times. Factors to consider in choosing between them include:
• The level and importance of capital expenditures to the organization
• The maturity and sophistication of the organizations budget managers
• The maturity and sophistication of the organizations accounting team
• How the organization manages its cash flow, and its general liquidity position.

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