A capital expenditure is the purchase of an item that’s considered a long-term investment, such as computer systems and equipment. Most companies follow the rule that any purchase over a certain dollar amount counts as a capital expenditure, while anything less is an operating expense. Operating expenses show up on the income statement, and thus reduce profit. Capital expenditures show up on the balance sheet; only the depreciation of a piece of capital equipment appears on the income statement.
Taking a big purchase off the income statement and putting it on the balance sheet, so that only the depreciation shows up as a charge against profits, can have the effect of increasing profits. Take WorldCom, a large portion of this big telecom company’s expenses consisted of operating expenses called line costs. These were fees paid to local phone companies to use their phone lines. Line costs were normally treated as ordinary operating expenses, but they argued (albeit incorrectly) that some of them were actually investments in new markets and wouldn’t start paying off for years. That was the logic pursued by CFO Scott Sullivan who began “capitalizing” his company’s line costs in the late 1990’s. Bingo: these expenses disappeared off the income statement, and profits rose by billions of dollars. To Wall Street, it appeared that WorldCom was suddenly generating profits in a down industry – and no one caught on until later, when the whole house of cards collapsed.
(Excerpts from Financial Intelligence, Chapter 1 – You Can’t Always Trust the Numbers)
An example of the artful work of finance – and another one that played a huge role in recent financial scandals – is determining whether a given cost is a capital expenditure or an operating expense. You can see the temptation here. Wait. You mean if we take all those office supply purchases and call them “capital expenditures,” we can increase our profit accordingly? This is the kind of thinking that got WorldCom into trouble. To prevent such temptation, both the accounting profession and individual companies have rules about what must be classified where. But the rules leave a good deal up to individual judgment and discretion. Again, those judgments can affect a company’s profit, and hence its stock price, dramatically.