What is a capital expenditure?

How Lodging-Industry Financial Executives Decide

Lodging-industry financial executives want guidelines that will help them know when to capitalize an expenditure versus charging that expense to that year's revenues.

In the course of a year, the average hospitality firm makes a huge number

of expenditures. In general, most of them are easily classified as revenue expenses, since their benefits are realized within a year. As such, revenue expenses are offset against the revenue of the year in which they are incurred. On the other hand, capital expenditures are those whose benefits are realized over a time greater than a year.(1)

Many expenditures, such as the purchase of land, buildings, and most equipment, are easily classified as capital expenditures. Our research, however, indicates that many transactions are difficult to classify. For example, how many inches of bituminous asphalt on a driveway constitutes a capital expenditure? Is a one-inch-thick layer considered a revenue expense and two inches a capital purchase? When a hotel upgrades from mechanical to electronic locks on guest-room doors, is a $100 cost per room considered a revenue expenditure and a $300 cost per room a capital expenditure?

The importance of having tight guidelines regarding how to classify expenses is magnified by the clash of incentives between a property owner and the management company. Owners have an incentive to classify as many items as possible as revenue expenditures (expenses) as opposed to capital expenditures because expenses reduce current income and, as a result, current taxes. On the other hand, managers have an incentive to capitalize as much as possible because a portion of the management fee is based on net operating income (NOI), which does not include capital expenditures. Therefore, if items are capitalized rather than treated as expenses, NOI - and therefore the management fee - is bigger. (In fact, that contract arrangement encourages some managers to defer maintenance that thereafter causes major repairs to be needed - repairs that can be capitalized.)

A Dearth of Research

A considerable amount of research has been done on the subject of capital budgeting in the hospitality industry. The research focus, however, has been on the techniques of capital-budgeting analysis, such as the use of discounted-cash-flow models, rather than on the appropriate accounting for items acquired.

Eyster and Geller did a comprehensive study that reported the percentage of hospitality firms that employed the commonly used capital-budgeting techniques such as payback, net present value, and internal rate of return.(2) Two of this paper's authors did a follow-up study that revealed a change from 1981 to 1990, an increased use of the discounted-cash-flow methods, and also reported on a change in the use of certain other capital-budgeting techniques.(3)

Another general study of hotel capital budgeting in the 1990s was done by Berg and French.(4) Andrew and Eggell conducted research in the capital-budgeting area, but once again the study dealt with specific techniques, such as the relative use of net present value as opposed to internal rate of return.(5) Wilson, Nussbaum, and Sheel studied and reported on the capital-budgeting techniques for use in hotel-renovation situations.(6)

In all those studies the researchers had already determined that the expenditures involved in the study were capital in nature, and the discussion revolved around an evaluation of the quality of the proposed expenditure. Authors made virtually no mention about how a financial manager discerns whether an expenditure is revenue or capital in nature.

Other researchers examined the proper amount of capital expenditures to make annually,(7) while another studied the importance of proper accounting for public-sector capital expenditures.(8) Also, Kerstein and Sungsoo investigated whether capital expenditures are a reliable source of information to project future earnings,(9) Stephens expressed the need for more standardization of data on capital expenditures to make real-estate assets more secure,(10) and Blackman explained the benefits of having an accountant justify a company's expenditure policy before the IRS.(11) But none of the research provides any substantial assistance in classifying expenditures as either revenue or capital.

Little help is provided either by the Internal Revenue Service or as part of Generally Accepted Accounting Principles (GAAP). In 1981 the IRS provided some general guidelines for classifying certain property as capital in nature through its Accelerated Cost Recovery System. In 1986 the IRS altered that system by establishing the Modified Accelerated Cost Recovery Systems. Both systems are too general to provide guidance in classifying expenditures.

Exhibit 1

Survey-sample profile

Property                             Number of      Percentage
size                                 responses       (n = 73)

501 or more rooms                      22                30%
251 to 500 rooms                       24                33%
101 to 250 rooms                       21                29%
100 or fewer rooms                      6                 8%

Management                            Number of     Percentage
arrangement                           responses       (n = 73)

Owner managed                           35               48%
Management company                      33               45%
Chain operated                           5                7%

Annual gross revenue
Range = $5 million to more than $450 million
Median = $12.5 million

Annual capital expenditures
Range = $400,000 to $690,000
Median = $650,000 (1995)
Exhibit 2

Capital expenditures by year

Year     n             Range                Median

1995     61         $50,000-23,100,000     $650,000
1994     61         $20,000-19,500,000     $655,000
1993     55         $5,000-3,900,000       $400,000
1992     52         $15,000-5,200,000      $485,000
1991     45         $25,000-6,052,000      $480,000
1990     34         $25,000-12,000,000     $425,000
1989     28         $50,000-7,054,000      $695,000
Exhibit 3

Capital expenditures by property size (1995)

Property size               n          Range              Median

[less than] 101 rooms       4     $263,000-3,100,000    $1,450,000
101-250 rooms              18     $50,000-1,600,000     $582,750
251-500 rooms              22     $85,000-4,600,000     $355,550
[greater than] 500 rooms   17     $225,000-23,100,000   $2,100,000

GAAP provides few references to the classification of specific expenditures as capital or revenue in nature. For example, the Financial Accounting Standards Board (FASB) in 1974 declared that research and development costs were to be accounted for as revenue expenditures and not capitalized.(12) The FASB provided guidelines for accounting for motion-picture films in 1981 and computer software in 1985.(13) Earlier the FASB had provided insight into the area of computer software as it related to research and development costs.(14)

Research Methodology

To investigate the area of capital expenditures for the hospitality industry, we mailed a questionnaire, after fine-tuning it by pretesting the survey, to 600 controllers of individual hotels. We selected the potential respondents randomly from among the lodging controllers listed in the current member directory of the International Association of Hospitality Accountants (IAHA). Surveys were returned by 73 respondents, for a 12-percent response rate.

The survey instrument had two parts. The first part asked for demographic information, such as the operating structure of the hotel and the number of rooms. The second part was designed to obtain information that would answer our two main research questions: (1) What criteria are most often used by lodging-industry financial executives when making decisions to capitalize expenditures, and (2) How clear are the current criteria regarding the capital-expenditure decision in the lodging industry.

We analyzed the data using both descriptive statistics and a cross-tabulation analysis.

To be sure, we recognize that the sample of hotels surveyed by our study technique is not representative of the U.S. lodging industry as a whole. For example, while hotels and motels with under 100 rooms are abundant nationwide, it is unlikely that they would have a "financial executive" and, even if they did, it is unlikely that she or he would be a member of the IAHA. Nevertheless, we believe the 73 responses to our study represent a reasonable cross section of lodging properties' experiences regarding spending and accounting for capital improvements.

Demographic Profile of Respondents

Twenty-four (33 percent) of the respondents were affiliated with properties of 251 to 500 rooms, 22 (30 percent) had over 500 rooms, 21 (29 percent) had 101 to 250 rooms, and six (8 percent) had 100 or fewer rooms (see Exhibit 1). Most (39, or 53 percent) of the respondents' properties were built after 1981. At the other extreme, three (4 percent) were built before 1900.

The annual gross revenue for the properties ranged from below $5 million to over $450 million; the median was $12.5 million. The most common operating structure was management by owners (35 properties, or 48 percent), followed by management companies (33, or 45 percent) and chains (5, or 7 percent).

The median amount of annual capital expenditures in 1995 was $650,000, or 5.2 percent of median gross revenues. The range of the medians for annual capital expenditures was $400,000 in 1993 to $695,000 in 1989 (Exhibit 2). Capital expenditures by property size for 1995 are shown in Exhibit 3.

Exhibit 4

Level of uncertainty about capitalizing an expenditure

                                Number of    Percentage
                                responses    (n = 71(*))

Often                                5            7%
Sometimes                           39           55%
Seldom                              18           25%
Never                                9           13%
Total                               71           100%

* Two of the study's 73 participants did not respond to this
question.
Exhibit 5

Level of agreement that guidelines for capitalizing expenditures
are needed

                                Number of        Percentage
                                responses        (n = 72(*))

Strongly agree                    21                29%
Agree                             32                44%
Neutral                            9                13%
Disagree                           5                 7%
Strongly disagree                  5                 7%

Total                             72                100%

* One of the study's 73 participants did not respond to this
question.

[TABULAR DATA FOR EXHIBIT 6 OMITTED]

[TABULAR DATA FOR EXHIBIT 7 OMITTED]

Findings

Owing to the lack of guidelines from either the IRS or GAAP, there is considerable uncertainty among hospitality financial managers about whether certain expenditures are revenue or capital in nature (see Exhibit 4). Only 13 percent of the 71 respondents who answered this question reported that they are never unsure of the treatment, while over half (55 percent) reported that they are sometimes unsure, and 7 percent said that they are often unsure.

Need for guidelines. Twenty-one of 72 respondents (29 percent) strongly agreed that guidelines for determining whether to capitalize an expenditure should be established, 32 agreed (44 percent), and nine were neutral (13 percent); only 10 disagreed (14 percent). Clearly, a large majority of respondents believe guidelines should be established (see Exhibit 5).

Respondents were also asked who should establish the guidelines (see Exhibit 6) and we received 60 responses. The largest percentage (33 percent, or 20 respondents) indicated that it should be the IAHA; 18 percent (11 respondents), the FASB; 15 percent (9 respondents),the American Institute of Certified Public Accountants (AICPA); and 8 percent (5 respondents), the lodging industry (e.g., the AH&MA).

The responses in favor of the IAHA's setting the guidelines may well be due to the survey sample's having been selected from the IAHA membership. Even so, IAHA members are probably among the most knowledgeable about the financial aspects of the lodging industry and are therefore in a good position to establish the guidelines.

Criteria used for purchases. Respondents were questioned regarding criteria they used for determining whether the purchase of equipment should be capitalized (see Exhibit 7). We provided six criteria and asked the respondents to indicate which were relevant for each of eight categories of purchases. We asked respondents who chose the criterion "when purchase is over a certain dollar amount" to state the amount, and we asked respondents who use criteria other than those listed to specify them.

Nearly half the respondents (36 individuals) reported that the criterion "when purchase is part of property and equipment at time hotel is purchased" is used to determine whether the purchase of furniture is capitalized. Just over 60 percent of the respondents (44 individuals) said that the criterion "when purchase is part of hotel renovation" is used to determine whether furniture is capitalized.

The criterion used by the largest number of respondents is "when purchase is over a certain dollar amount." That criterion received the largest response from respondents for six of the eight purchase categories. For each purchase category the median dollar amount related to that criterion was $1,000. The range of values for the eight purchase categories was $100 to $10,000. The most common amount for each category was $1,000, followed by $500.

The next most commonly used criterion was "when the purchase is part of a hotel renovation." In fact, for two of the categories, furnishings and floor coverings, it was the most commonly used criterion.

Surprisingly, some respondents reported that they never capitalize certain categories of purchases. However, across all purchase categories that response was low, ranging from 0 to only 4 [TABULAR DATA FOR EXHIBIT 8 OMITTED] percent.

Some respondents used criteria not listed on the questionnaire. Examples include "not recurring maintenance" and "not a repair" for electrical, mechanical, and HVAC equipment; "when approved by ownership" for all eight purchase categories; and "when entire room is renovated" for furnishings.

Criteria used for repairs. Respondents were also asked to specify criteria used for capitalizing material and labor expenditures related to the repair or renovation of existing buildings and furniture, fixtures, and equipment (see Exhibit 8). The criteria listed on the questionnaire were (1) "when instructed by owners or upper management," (2) the improvement prolongs the useful life of the property," (3) "the improvement increases the earning capacity of the property," and (4) "the improvement is over a certain dollar amount" (respondents were asked to specify the amount). Space was provided for respondents to indicate other criteria that they use.

About 28 percent of the respondents indicated that expenditures for material and labor related to the repair or renovation of furniture are capitalized when the owner requested that the repairs be capitalized. About 61 percent (45 individuals) use the criterion "when the cost of the improvement is over a certain dollar amount" for the capitalization of furniture repairs or renovation.

For each of the 12 categories, the median amount of the material and labor expenditure related to the category "when the cost of the improvement is over a certain dollar amount" was $1,000. The range was $100 to $20,000. The mode for each category was also $1,000.

The most common response was "the improvement prolongs the useful life of the property." The second most common was "the improvement is over a certain dollar amount." The least common was "the improvement increases the earning capacity of the property."

Some respondents mentioned other criteria, including "if it is part of the capital budget" for all 12 items, "if it is a renovation of furniture" and "if it is a complete renovation of a specific area" for furnishings and floor coverings, and "when it is part of the entire computer system rather than a single computer."

Wanted: Guidelines

There is a lack of guidelines for the recording of capital expenditures in the hospitality industry, and accounting practitioners would like to see such guidelines developed. The financial-management committee of the AH&MA, the group that revised the Uniform System of Accounts for the Lodging Industry in October 1996, may be ideally positioned and skilled to take on this responsibility. The committee comprises lodging-industry financial executives, hotel consultants, and hospitality financial-management educators. Moreover, most of those individuals are also IAHA members. That committee, which already has a proven track record of providing financial guidance to the lodging industry, could therefore provide an excellent representation of both the lodging industry and the IAHA.

The hospitality industry has established a uniform system of accounts that is intended to be a turnkey system. Now, guidelines for capital expenditures should be established by the industry and integrated into the uniform system of accounts.

1 William P. Andrew and Raymond S. Schmidgall, Financial Management for the Hospitality Industry (East Lansing, MI: Educational Institute of the American Hotel & Motel Association, 1993), p. 189.

2 J. Eyster and N. Geller,"The Capital Investment Decision: Techniques Used in the Hospitality Industry," Cornell Hotel and Restaurant Administration Quarterly, Vol. 22, No. 1 (May 1981), pp. 69-73.

3 R.S. Schmidgall and J.W. Damitio,"Current Capital Budgeting Practices of Major Lodging Chains," Real Estate Review, Vol. 20, No. 3 (1990), pp. 40-45; and R.S. Schmidgall and J.W. Damitio, "Hotels and Long-Term Investment," Bottom Line, Vol. 5, No. 4 (1990), pp. 22-25.

4 P. Berg and T French, "Capital Expenditures in the '90s," Lodging, Vol. 28, No. 1 (1995), pp. 103-106.

5 W. Andrew and J. Eggell, "Hospitality Valuation: The Correct Specification and Use of the Variance Approaches to Present Value," Journal of Hospitality Financial Management, Vol. 4, No. 1 (1995-96), pp. 15-24.

6 R.H. Wilson, E. Nussbaum, and A. Sheel, "Hotel Renovation: A Capital Budgeting Problem." Journal of Hospitality Financial Management, Vol. 4, No. 1 (1995-96), pp. 43-53.

7 Peggy Berg and Mark Skinner,"CapEx: Do You Spend Enough?," Lodging Hospitality, Vol. 51, No. 11 (December 1995), p. 103.

8 Beverly S. Bunch," Current Practices and Issues in Capital Budgeting and Reporting," Public Budgeting & Finance, Vol. 16, No. 2 (Summer 1996), p. 7. This article deals with the importance of proper accounting for capital expenditures in the public sector.

9 Joseph Kerstein and Kim Sungsoo, "The Incremental Informational Content of Capital Expenditures," Accounting Review, Vol. 70, No. 3 (July 1995),p. 513.

10 Paula Stephens, "A Call for Standardization," National Real Estate Investor, Vol. 36, No. 9 (September 1994), p. 4.

11 Irving Blackman,"To Capitalize or to Expense: That's the Question on Repairs," Contractor, Vol. 42, No. 8 (August 1995), p. 34.

12 Financial Accounting Standards Board, "Accounting for Research and Development Costs," FASB No. 2, October 1974.

13 Financial Accounting Standards Board,"Accounting for Motion Picture Films," FASB No. 53, December 1981; and Financial Accounting Standards Board, "Accounting for the Costs of Computer Software to Be Sold, Cleared or Otherwise Mandated," FASB No. 86, August 1985.

14 Financial Accounting Standards Board, "Applicability of FASB No. 2 to Computer Software," FASB Interpretation 6, February 1975.

Raymond S. Schmidgall, Ph.D., CPA, is the Hilton Hotels Professor at Michigan State University's School of Hospitality Business. James W. Damitio, Ph.D., CMA, is a professor of accounting at Central Michigan University. A. J. Singh is a doctoral candidate in parks and recreation management at Michigan State University.