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Companies follow a strategy that ensures profitability and future growth. As a part of this strategy, they decide how to run their operations. Usually, it also entails assessing the assets required to run those operations. If needed, companies can go through capital addition to support activities.
What is Capital Addition?
Capital addition involves acquiring new assets to enhance a company’s operations. These assets are viewed as long-term investments and include physical items like equipment or real estate and intangible assets like patents or software. The primary distinction is that capital additions are significant expenditures meant to provide benefits over a prolonged period, typically beyond a year.
Companies carefully plan and assess these additions to align with their strategic goals. Accounting for capital additions involves recording the asset’s cost on the balance sheet and gradually reducing its value over its expected useful life. This approach ensures that expenses match the revenue recognition principles, reflecting the asset’s value over time.
What is the accounting for Capital Addition?
Accounting for capital additions involves a structured process to manage the acquisition of new assets efficiently. Initially, when a company acquires a new capital asset, it records the total cost on the balance sheet. This cost encompasses the purchase price and any ancillary expenses needed to prepare the resource for its intended use, such as installation or legal fees.
The cost is then capitalized under the appropriate asset account on the balance sheet, signifying its long-term nature. Over time, the asset’s value gradually gets consumed, leading to depreciation (for tangible assets) or amortization (for intangible assets). These expenses are reported on the income statement and reduce the asset’s recorded value on the balance sheet.
What is the journal entry for Capital Addition?
The journal entry for capital addition is straightforward. Primarily, it involves capitalizing the costs of the asset or resource a company purchases. This process requires the following journal entry.
| Dr | Asset |
| Cr | Bank or cash or payable |
Over time, the company must also record depreciation or amortization on the capitalized amount. This process occurs through a strategic allocation of the asset’s cost over its useful life. Once a company determines the amount for depreciation or amortization, it uses the following journal entry to record the transaction.
| Dr | Depreciation |
| Cr | Accumulated depreciation |
For amortization, the journal entry will be as follows.
| Dr | Amortization |
| Cr | Accumulated amortization |
Example
A company, Red Co., purchases a new plant as a part of its strategy to add capital to its operations. Red Co. pays a total of $50,000 to acquire the asset funded by its bank account. The company uses the following journal entry to record the transaction.
| Dr | Plant | $50,000 |
| Cr | Bank | $50,000 |
Red Co. expects to use the plant for the next 10 years. Based on this, the company determines the annual depreciation charge for the asset is $5,000. Red Co. records the depreciation on the plant as follows.
| Dr | Depreciation | $5,000 |
| Cr | Accumulated depreciation | $5,000 |
The depreciation on the plant decreases its book value on the balance sheet. On the other hand, it also increases the expense for the current period in the income statement.
Conclusion
Capital addition refers to the process companies undergo to acquire new assets to improve operations. Usually, companies add resources to their operations as a part of their strategy. The accounting for these assets involves capitalizing the costs under the relevant accounting standard. On top of that, it also entails tracking the asset’s book value over time and recognizing depreciation or amortization.
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