Editorial Note: This article was brought to you courtesy of Rose Morrison, managing editor of Renovated.com.
Construction projects are costly, so getting the financial situation right is essential for business owners. Some purchasing decisions are straightforward, with clear guidelines on what to do. However, others lead to a gray area for the accounting department. Should you consider your purchase an expense, or should you capitalize it?
Each has benefits, but determining the right path is vital for complying with the law and company policy. Here’s a guide on deciding between capitalization and expenses for your construction costs.
What Is Expensing?
This process entails detailing your purchases on your profit-and-loss (P&L) statement. You’ll add the items and subtract them from your revenue to determine your profit. Your net profit will decrease, but your P&L statement will reflect your financial decisions.
When Should You Expense?
You should write off most inexpensive items as expenses. Think about the materials you buy with less ability to hold their value, like the clothing and equipment your crew wears. Hard hats are sturdy but deteriorate over time. You must ensure everyone’s hat meets OSHA standards to protect from shocks, burns and falling objects.
Your construction team will also expense items you’ll use and won’t return. For example, a project will likely require nails, screws, paint, insulation and other goods. Once these items are in place, you won’t be able to resell them later. Therefore, they’ll end up as an expense on your P&L statement.
Expenses are a common decision in the construction world. Here are a few more items you’ll likely expense on your P&L statement:
- Permits: Obtaining permits and licenses is a crucial first step in setting up your project. Building permits can cost up to $2,000 for major projects, depending on your location and local policies. This purchase will be an expense.
- Fees: During the project, you may need help from outside services to survey the land, draw designs and make structural calculations. These fees count as expenses on your P&L statement.
- Tools: When you buy drills, hammers and other tools, you typically don’t expect to sell them down the line.
- Transportation: Getting to the construction site requires fuel and logistics for your heavy equipment. Gas and diesel can be cumbersome due to costs and emissions, and they’ll count as expenses for your business. Industry professionals are starting to use electric vehicles to lessen this financial burden.
- Repairs: Occasionally, you’ll need to repair your tools and equipment. You can capitalize some significant repairs, but most of your minor fixes will count as expenses in your budget.
What Are the Benefits of Expensing?
Expensing is standard in the construction business, especially for your accounting department. While it might not bring future rewards, it comes with these benefits.
Clear Financial Reporting
Expensing your purchases is a more black-and-white financial decision. Your tools, work clothes, permits and fees will take away from the revenue to generate a net profit, making you stick to a budget. If your P&L statement consists primarily of expenses, your shareholders and other parties involved will have a much easier time deciphering the health of your construction projects.
Easier Purchasing Decisions
Expenses make your financial statements more straightforward for everybody at your business. With this information, project managers better understand the team’s financials and can make better purchasing decisions.
Budgets are tight nowadays, so knowing where every dollar goes is essential. For example, land surveying costs around $528 on average but can easily eclipse the $700 mark. Project managers will have an easier time determining where this expense fits in the budget if it’s an expense rather than a capital expenditure. The team will know this cost going in, and it will reflect on the P&L statement.
Making Accounting Easier
The accounting department is responsible for monitoring where the dollars are moving throughout the construction process. Expenses make their lives easier because they’re easier to record. Your costs should align perfectly with the matching principle, ensuring you have your revenue and purchases in the same timeframe. Capitalized assets require accounting to watch them over time, adding extra work for the team.
Earning Tax Deductions
Some people see expenses as the less-lucrative financial path because you’re not gaining or maintaining an investment. However, expenses can still benefit your company through tax deductions. The Internal Revenue Service (IRS) allows businesses to deduct necessary expenses, thus reducing their tax liability.
For example, your construction business may spend money throughout the year on radio, TV and social media advertising. The IRS says these expenses are deductible because they tie directly to your company and advertising is a common practice in the industry.
Taking Fewer Risks
Expensing your purchases is a more straightforward and less risky process than capitalization. Capitalizing an asset carries the chance you could overvalue it and mess up your finances. Construction budgets are often tight, with stakeholders risking lots of money. The National Association of Home Builders says building a single-family home cost about $644,750 in 2022. Expensing is typically the safer route.
What Is Capitalization?
Your other financial option in construction is capitalization. This method includes marking your purchase as an asset instead of an expense. The payment method is still the same — you spend capital to acquire something. However, this object has value and contributes to your business’ value.
When Should You Capitalize?
Capitalization usually happens with significant purchases. For example, suppose your company has purchased a new excavator. This machine typically costs you six figures, making it a challenging acquisition. Luckily, you can record it as a capital expenditure because of the value it adds to your business. Excavators are essential for digging trenches and starting many construction projects, letting you mark them as assets.
The prices will still show up on your balance sheet but will be less intimidating because it won’t be on your P&L statement. Your asset’s depreciation will appear on financial statements over time, letting you monitor their value as you own it.
Most large purchases end up as assets. Another criterion for capital expenditures is something you plan to use for a long time. Nonetheless, here are some examples of what you should consider a capital expenditure in the construction world:
- Land: Acquiring land is an essential first step in construction and can cost a lot of money. The cost depends on your location, but research shows an average of around $4,080 per acre in 2023. You’ll need the land for the duration of your project and beyond, so it’s a capital expenditure.
- Labor: Labor is not a tangible asset but counts as a capital expenditure because it adds value to your project over time. You’ll purchase labor and will make revenue off it.
- Equipment: The same logic for labor applies to your equipment. Excavators, bulldozers, cranes and more qualify for capitalization if you buy them outright. If you rent your equipment instead of buying it, this purchase should go under the expense category.
- Start-up: Entrepreneurs may decide to establish a start-up to enter the construction industry. The associated expenses will decrease as capital expenditures, so consider the business plan, vehicles and construction management software.
- Insurance: Insurance is a critical long-term asset due to the dangers of the industry. The Bureau of Labor Statistics says 46% of fatal falls and slips happened in construction. Insurance is a permanent need, so it falls under capitalization.
What Are the Benefits of Capitalization?
Capitalization can be more complex and risky than expensing. Still, it brings these five benefits to your team.
Managing Your ROI
Capitalization lets you monitor your assets’ value as they appear on your financial statements. Ideally, These investments will be helpful for a long time and generate revenue. Some purchases could hold their value, while others depreciate over time.
Depreciation is most common for construction vehicles, as heavy use will cause wear and tear. Your team can utilize maintenance schedules and daily inspections to ensure your equipment exceeds its life expectancy. You’ll move the money from assets to expenses as the vehicle depreciates, but you can slow the depreciation with smart maintenance.
Conversely, you’ll have appreciating assets like land. Most pieces of land will increase in value depending on its maintenance and the infrastructure added. Also, it will benefit the developer for more than a year. USDA data shows an 8.1% increase in land value between 2022 and 2023.
Increasing Company Value
If you own a construction company, you’re likely happy with where you are. Family-owned businesses are especially tight, as the owners pass the organization down through the generations.
Some construction business owners sell the company for one reason or another, so it helps to have capital expenditures in this instance. Potential buyers like to see valuable assets and solid financial statements, as your company’s value will be higher.
Securing Financing
Financing can be difficult for construction businesses, so having a good line of credit and solid financial statements is essential. Lenders will look at your records to see if you have everything in order. Responsible asset tracking will increase the likelihood of better terms with the lender.
Reducing Your Tax Liability
Like expensing, capitalization brings tax benefits for your construction business. The IRS lets you deduct depreciation and count them as expenses as you use your capital assets. Therefore, your taxable income for the year will be lower. In 2023, the IRS changed the maximum section 179 expense to $1.16 million. Capital expenditures may be expensive, but they’ll save money along the way.
Following the Rules
It’s essential to follow the rules when dealing with multimillion-dollar enterprises. Some construction expenses require capitalization because your accounting team must follow the Generally Accepted Accounting Principles from the Department of Justice. Audits might not come for your business, but it’s best to prepare and get your ducks in a row. Capitalizing the correct expenses means you abide by the law.
Managing Your Construction Team’s Financials
Purchasing the right tools for the job isn’t always black and white. In construction, you can write off expenses or classify something as a capital expenditure. Knowing the difference can save you time and money throughout the year, especially during tax season.
Expensing is typically for the team’s inexpensive purchases, such as tools and safety equipment. Capital expenditures include more significant costs benefiting the company for at least a year. Learn the difference to help your accounting team sail smoothly.
This is a guest post written by Rose Morrison, managing editor of Renovated.com.