Capital Asset

Capital asset has two related meanings in the fields of accounting and financial economics. In accounting, a capital asset is an asset that is recorded on a balance sheet as capital – that is, property that creates more property, e.g. a factory that creates shoes, or a forest that yields a quantity of wood. In financial economics, capital assets also include financial assets such as stocks or bonds.

Tax Accounting Treatment

The treatment of different types or kinds of capital asset varies very widely by jurisdiction. The GAAP only require that capital assets be treated differently from operating expenses, as the latter yield all their benefits immediately.

In the U.S., a capital asset is, generally speaking, an asset which produces a benefit that extends beyond the current tax year. (See Internal Revenue Code § 263). In most countries, including the U.S., a capital cost deduction applies to require or allow a purchaser to deduct the cost of acquiring the asset from one’s adjusted gross income either progressively over time (depreciation or amortization), or at the time of sale or disposition.

Delayed deduction for capital assets is favoured because it allows for tax liability to more accurately reflect individual income. When one invests in a long-term asset, it is assumed that the individual will realize income (or some other benefit) from that asset in the future, rather than right away. If the benefit of the asset is likely to gradually fade over time, the cost of the asset may be depreciated or amortized. The period of time over which this occurs can range typically from 2 years for software to 30 years for buildings. If the benefit will likely not be realized until the sale or disposition of the asset, then the cost of the asset may be deducted only at that time. In either case, the ability to deduct the cost of the capital asset is dependant on the taxpayer’s adjusted basis in the asset.

Under 26 U.S.C. § 1221, capital assets are defined as “property held by the taxpayer (whether or not connected with his trade or business), but does not include…” and then the section goes on to list such exceptions as inventory, certain newly created intangible property and depreciable property held by a business.

Management Accounting Treatment

Capital asset accounting is more difficult when intangibles are considered, most notably in the managing of human capital. Because some theory of value creation must be used to assess the contribution of the different elements of human capital, this is considered a management accounting problem to which few fixed standards have so far been applied.

However, rampant speculation and potential for creative accounting and accounting scandal is involved when intangibles are a large part of a company’s value. Most such recent US scandals involved high-tech companies during the dotcom boom that could represent their software, teams of engineers and loyalty of their customers rather arbitrarily, since there was little to which to compare these before the Internet era.

Breaking down the intangibles that go into human capital into the instructional capital followed to do things, the individual capital talent, and the social capital between them and the customers that allows them to trust each other and get things done, is an approach sometimes advised.

In sports economics and in public sector efforts at measuring well-being, and other specialized fields there is a need to try to gauge these intangibles for a group of people in a team or a whole society. This is a very difficult issue: For example, a professional sports team becomes more valuable due to their ability to coach players with training programs and rules, but those players have only so much natural talent, and the chemistry between them is important. Accordingly, the valuation of the team is very difficult, and may vary from year to year. Typically only selling the team would be a fair indication of its fair market value, and the sale itself, especially if it involved moving to another city, would drastically alter some of these factors (such as the fan base which provides the players with fame and encouragement, or the ability to attract new talent to the team).

Common Auditing

Avoiding the question of human capital and its intangibles, the focus in ISO standards for performance audits suggests that capital assets can be evaluated first for what they do and only second for what they are worth. That is, building a model of what activities or service economy or service product the capital asset supports, makes it easier to compare, unlike physical goods. Consider two different ways to pollinate an orchard: by paying people to do it, or by letting bees do it. The beehive or meadow, and the road or truck, each bring in those who do the pollination, so should be treated equally.

The ISO 19011 standard may be a step in this direction, as it combines environmental management (for natural capital assets) with quality management (for humans) into a single audit. It is however not clearly a method suited for capital asset valuations, though it provides a framework to distinguish types of assets based on what activities they support. This would permit an activity-based costing or throughput accounting model to be quite easily constructed.

The Natural Capitalism approach goes further and advises a single uniform way of dealing with natural capital as an asset equivalent to infrastructural capital, financial capital and human capital, although it says nothing about how to combine these into a single total cost of operations.

In Financial Economics

The capital asset pricing model was developed to answer questions on the pricing of capital assets.

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