What is Capital Improvement?
Capital Improvement is a kind of Capital (big) expenditure mainly in the assets of the company like repairing of the building or changing a part of production machine or something similar which will increase the life of that asset as well as will result in future economic benefits to the company incurring the capital expenditure by way of the increased life of the asset or better performance of the asset.
- #1 – Recurring – This refers to those expenditures which need to be done within a fixed span of time due to the usage of that asset or due to the particular asset requirement.
- #2 – Non-Recurring – This refers to those capital expenditures which a company incurs when they are of the view that incurring such expenditure is required, and it will increase the life of the asset.
Examples of Capital Improvement
Suppose a US-based company B Inc. owns many auditoriums in different parts of the US. This company is in this business since 1985. In 2015, the company management was of the view that the assets used in the auditorium like Push back chairs, Sofa sets, Air conditioners, lighting arrangements, flooring needs to be completely changed because it has been 30 years. Since then, no renovation has been done. Also, to compete in a challenging environment, it needs to be up to date with many new technologies and better comfort. So, for this, the company incurred a total of $750,000 on all the assets for the renovation of all its auditoriums.
This expenditure will increase the life of auditoriums and will also result in future economic benefits, i.e., more and more people will come and enjoy their entertainment time comfortably. So, this is a kind of capital expenditure which the company will capitalize on respective assets and will not expense it off in income statement.
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An Ltd, dealing in the manufacturing of passenger cars, has a lot of big machines in its production plant. These, if stopped or do not work correctly, will result in substantial revenue losses for the company. Considering this, the management of the company decides to examine the conditions of the machines regularly. In 2018 they found out that two machines were about to stop working properly due to its continuous usage. Still, if some parts of the machine could be replaced, then they will be back in the original condition and will work for another 5 years without any downtime. For this, the company incurred a total of $ 10,000,000 on both the machines.
Consequently, both machines started working properly, thus increasing the life of those machines as well as resulting in future economic benefits to the company. So this is an example of capital improvement.
- Capital improvement increases the life of assets and results in the future economic benefits of the company.
- It helps the company to retain its image in the market by providing updated facilities.
- Companies can retain the asset for a more extended period.
- It helps in more depreciation claims for the company due to the increased cost of the asset as well as life.
- Capital improvement helps the company to save the downtime on assets due to the updation in it.
- It helps the company to maintain its revenue year over year and sometimes increase as well.
- It helps the company in retaining its employees for a longer period of time due to the better working of the assets and a better work environment.
- Capital investment leads to the huge outflow of the company’s funds.
- In capital improvement asset is not replaced with a new one. It results in old assets or not using the latest technologies.
- It can lead to misappropriation of funds by the company resulting in fraud.
- Sometimes there is unnecessarily investing in assets even when not required just to divert the funds.
- With huge investment comes the huge risk associated with it, i.e., the risk of failure of assets even after invoking new parts.
- Every company may not be able to invoke such huge funds due to their poor financial condition.
- Every time an asset cannot be just updated, sometimes it needs to be fully charged with a new and latest technology.
- Investing a large amount needs a lot of planning and professional judgments regarding the benefits and risks associated with capital expenditure.
- Arranging funds from outside is also not an easy task for the companies having lower credibility.
- Consent of all the stakeholders is needed for a huge amount to be invested, which at times becomes tough for the companies as many of them may not agree to the same.
The different important points related to the Capital Improvement are as follows:
- Before going for capital improvement, the company must determine whether there is a requirement of such expenditure at that time or not. It requires to consider the benefits and risks associated with the cost.
- The company should consider the relevant laws and regulations for that particular industry or any changes coming in future years.
- Determine the interest cost on the funds to be borrowed for capital expenditure.
Capital Improvement is always dependent on factors. E.g., nature of assets, type of industry you are dealing in, investment amount, related benefits, related risks, etc. Just for the benefits part, a company should never incur a huge amount in capital improvements; because if there is no proper planning in advance, the benefit can even turn out into major loss.
It is always better to take financial advice from some experts considering all the factors related to capital improvement; take acceptance of all the stakeholders; study the relevant laws and regulations, determine the interest cost payable. Most essentially determine whether the requirement is of improvement or a complete change at that point in time. Also, ensure that it always be capitalized and should never be expensed off in the income statement of the company.
This article has been a guide to what is a capital improvement and its definition. Here we discuss types and practical examples of capital improvement along with advantages and disadvantages. You may learn more about our articles below on finance–