Fixed capital

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In economics and accounting, fixed capital is any kind of real, physical asset that is used in the production of a product but is not used up in the production. It contrasts with circulating capital such as raw materials, operating expenses and the like. It was first theoretically analyzed in some depth by the economist David Ricardo.

Economics Social science that analyzes the production, distribution, and consumption of goods and services

Economics is the social science that studies the production, distribution, and consumption of goods and services.

Accounting measurement, processing and communication of financial information about economic entities

Accounting or accountancy is the measurement, processing, and communication of financial information about economic entities such as businesses and corporations. The modern field was established by the Italian mathematician Luca Pacioli in 1494. Accounting, which has been called the "language of business", measures the results of an organization's economic activities and conveys this information to a variety of users, including investors, creditors, management, and regulators. Practitioners of accounting are known as accountants. The terms "accounting" and "financial reporting" are often used as synonyms.

Asset economic resource, from which future economic benefits are expected

In financial accounting, an asset is any resource owned by the business. Anything tangible or intangible that can be owned or controlled to produce value and that is held by a company to produce positive economic value is an asset. Simply stated, assets represent value of ownership that can be converted into cash. The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.

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Thus fixed capital is that portion of the total capital outlay that is invested in fixed assets (such as land improvements, buildings, vehicles, plant and equipment), that stay in the business almost permanently—or at the very least, for more than one accounting period. Fixed assets can be purchased by a business, in which case the business owns them. They can also be leased, hired or rented, if that is cheaper or more convenient, or if owning the fixed asset is practically impossible (for legal or technical reasons).

Refining the classical distinction between fixed and circulating capital in Das Kapital , Karl Marx emphasizes that the distinction is really purely relative, i.e. it refers only to the comparative rotation speeds (turnover time) of different types of physical capital assets. Fixed capital also "circulates", except that the circulation time is much longer, because a fixed asset may be held for 5, 10 or 20 years before it has yielded its value and is discarded for its salvage value. A fixed asset may also be resold and re-used, which often happens with vehicles and planes.

<i>Das Kapital</i> Book by Karl Marx

Das Kapital, also known as The Capital. Critique of Political Economy by Karl Marx is a foundational theoretical text in materialist philosophy, economics and politics. Marx aimed to reveal the economic patterns underpinning the capitalist mode of production, in contrast to classical political economists such as Adam Smith, Jean-Baptiste Say, David Ricardo and John Stuart Mill. Marx did not live to publish the planned second and third parts, but they were both completed from his notes and published after his death by his colleague Friedrich Engels. Das Kapital is the most cited book in the social sciences published before 1950.

Karl Marx Revolutionary socialist

Karl Marx was a German philosopher, economist, historian, sociologist, political theorist, journalist and socialist revolutionary.

In national accounts, fixed capital is conventionally defined as the stock of tangible, durable fixed assets owned or used by resident enterprises for more than one year. This includes plant, machinery, vehicles and equipment, installations and physical infrastructures, the value of land improvements, and buildings.

National accounts or national account systems (NAS) are the implementation of complete and consistent accounting techniques for measuring the economic activity of a nation. These include detailed underlying measures that rely on double-entry accounting. By design, such accounting makes the totals on both sides of an account equal even though they each measure different characteristics, for example production and the income from it. As a method, the subject is termed national accounting or, more generally, social accounting. Stated otherwise, national accounts as systems may be distinguished from the economic data associated with those systems. While sharing many common principles with business accounting, national accounts are based on economic concepts. One conceptual construct for representing flows of all economic transactions that take place in an economy is a social accounting matrix with accounts in each respective row-column entry.

The European system of national and regional accounts (ESA95) explicitly includes produced intangible assets (e.g. mineral exploitation, computer software, copyright protected entertainment, literary and artistics originals) within the definition of fixed assets.

Land itself is not included in the statistical concept of fixed capital, even though it is a fixed asset. The main reason is that land is not regarded as a product (a reproducible good). But the value of land improvements is included in the statistical concept of fixed capital, being regarded as the creation of value-added through production.

Estimating the value

Attempts have been made to estimate the value of the stock of fixed capital for the whole economy using direct enterprise surveys of "book value", administrative business records, tax assessments, and data on gross fixed capital formation, price inflation and depreciation schedules. A pioneer in this area was the economist Simon Kuznets. [1]

In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be "tangible book value".

Gross fixed capital formation

Gross fixed capital formation (GFCF) is a macroeconomic concept used in official national accounts such as the United Nations System of National Accounts (UNSNA), National Income and Product Accounts (NIPA) and the European System of Accounts (ESA). The concept dates back to the National Bureau of Economic Research (NBER) studies of Simon Kuznets of capital formation in the 1930s, and standard measures for it were adopted in the 1950s. Statistically it measures the value of acquisitions of new or existing fixed assets by the business sector, governments and "pure" households less disposals of fixed assets. GFCF is a component of the expenditure on gross domestic product (GDP), and thus shows something about how much of the new value added in the economy is invested rather than consumed.

Inflation increase in the general price level of goods and services in an economy over a period of time

In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time. The opposite of inflation is deflation.

The so-called "perpetual inventory method" (PIM) used to estimate fixed capital stocks was invented by Raymond W. Goldsmith in 1951 and subsequently used around the world. [2] The basic idea of the PIM method is, that one starts off from a benchmark asset figure, and adds on the net additions to fixed assets year by year (using gross fixed capital formation data), while deducting annual depreciation, all data being adjusted for price inflation using a capital expenditure price index. In this way, one obtains a time series of annual fixed capital stocks. This data series can also be modified further with various other adjustments for prices, asset lifetimes etc. (several variants of the PIM approach are nowadays used by economic historians and statisticians).

However, it is widely acknowledged that it is extremely difficult to obtain any accurate measurement of the value of fixed capital, especially because even the owner himself or herself may not know what the assets are currently "worth". What they are worth may become apparent only at the point where they are definitely sold for a price. Some valuations for fixed assets may refer to historic cost (acquisition cost) or book value, others to current replacement cost, current sale value in the market, or scrap value.

The depreciation write-off permitted for tax purposes may also diverge from so-called "economic depreciation" or "real" depreciation rates. Economic depreciation rates are calculated on the basis of the observed average market prices that depreciated assets at different ages actually sell for. Sometimes statisticians try to estimate the average "service lives" of fixed assets as a basis for calculating depreciation and scrap values, based on the observed length of time that fixed assets are actually held and used by their owners who own the business.

Almost always, the capital stock estimate which statisticians arrive at is a theoretical estimate based on a variety of data sources, and it does not correspond to the historical cost of fixed assets nor to actual depreciation write-offs. However, it is believed to be a more accurate representation of the true value of the fixed capital stock.

Investment risk

A business executive who invests in or accumulates fixed capital is tying up wealth in a fixed asset, hoping to make a future profit. Thus, such an investment usually implies a risk. Sometimes depreciation write-offs are also viewed partly as a compensation for this risk. Often leasing or renting a fixed asset (such as a vehicle) rather than buying it is preferred by enterprises because the cost of using it is lowered thereby, and the real owner may be able to obtain special tax advantages.

Sources of funding for fixed capital investment

An owner can obtain funding for purchase of fixed capital assets from the aptly named capital market, where loans are given on a long-term basis. Funding can also come from reserve funds, the selling of shares, and the issuing of debentures, bonds or other promissory notes.

Factors which influence fixed-capital requirements

See also

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Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced in a period of time, often annually. GDP (nominal) per capita does not, however, reflect differences in the cost of living and the inflation rates of the countries; therefore using a basis of GDP per capita at purchasing power parity (PPP) is arguably more useful when comparing differences in living standards between nations.

In economics, capital consists of an asset that can enhance one's power to perform economically useful work. For example, in a fundamental sense a stone or an arrow is capital for a caveman who can use it as a hunting instrument, while roads are capital for inhabitants of a city.

Depreciation Decrease in asset values, or the allocation of cost thereof

In accountancy, depreciation refers to two aspects of the same concept:

Fixed investment in economics is the purchasing of newly produced fixed capital. It is measured as a flow variable – that is, as an amount per unit of time.

In finance, a revaluation of fixed assets is an action that may be required to accurately describe the true value of the capital goods a business owns. This should be distinguished from planned depreciation, where the recorded decline in value of an asset is tied to its age.

Fixed asset assets and property that cannot easily be converted into cash

Fixed assets, also known as tangible assets or property, plant and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash. This can be compared with current assets such as cash or bank accounts, described as liquid assets. In most cases, only tangible assets are referred to as fixed.
IAS 16 defines Fixed Assets as assets whose future economic benefit is probable to flow into the entity, whose cost can be measured reliably. Fixed assets belong to one of 2 types: "Freehold Assets" – assets which are purchased with legal right of ownership and used, and "Leasehold Assets" – assets used by owner without legal right for a particular period of time.

In finance, leverage is any technique involving the use of debt rather than fresh equity in the purchase of an asset, with the expectation that the after-tax profit to equity holders from the transaction will exceed the borrowing cost, frequently by several multiples⁠ ⁠— hence the provenance of the word from the effect of a lever in physics, a simple machine which amplifies the application of a comparatively small input force into a correspondingly greater output force. Normally, the lender will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan. For example, for a residential property the finance provider may lend up to, say, 80% of the property's market value, for a commercial property it may be 70%, while on shares it may lend up to, say, 60% or none at all on certain volatile shares.

Consumption of fixed capital

Consumption of fixed capital (CFC) is a term used in business accounts, tax assessments and national accounts for depreciation of fixed assets. CFC is used in preference to "depreciation" to emphasize that fixed capital is used up in the process of generating new output, and because unlike depreciation it is not valued at historic cost but at current market value ; CFC may also include other expenses incurred in using or installing fixed assets beyond actual depreciation charges. Normally the term applies only to producing enterprises, but sometimes it applies also to real estate assets.

Value product

The value product (VP) is an economic concept formulated by Karl Marx in his critique of political economy during the 1860s, and used in Marxian social accounting theory for capitalist economies. Its annual monetary value is approximately equal to the netted sum of six flows of income generated by production:

Intermediate consumption is an economic concept used in national accounts, such as the United Nations System of National Accounts (UNSNA), the US National Income and Product Accounts (NIPA) and the European System of Accounts (ESA).

Operating surplus is an accounting concept used in national accounts statistics and in corporate and government accounts. It is the balancing item of the Generation of Income Account in the UNSNA. It may be used in macro-economics as a proxy for total pre-tax profit income, although entrepreneurial income may provide a better measure of business profits. According to the 2008 SNA, it is the measure of the surplus accruing from production before deducting property income, e.g., land rent and interest.

Net output is an accounting concept used in national accounts such as the United Nations System of National Accounts (UNSNA) and the NIPAs, and sometimes in corporate or government accounts. The concept was originally invented to measure the total net addition to a country's stock of wealth created by production during an accounting interval. The concept of net output is basically "gross revenue from production less the value of goods and services used up in that production". The idea is that if one deducts intermediate expenditures from the annual flow of income generated by production, one obtains a measure of the net new value in the new products created.

Capitalization rate is a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost or alternatively its current market value.

Capital formation

Capital formation is a concept used in macroeconomics, national accounts and financial economics. Occasionally it is also used in corporate accounts. It can be defined in three ways:

In economics, depreciation is the gradual decrease in the economic value of the capital stock of a firm, nation or other entity, either through physical depreciation, obsolescence or changes in the demand for the services of the capital in question. If the capital stock is in one period , gross (total) investment spending on newly produced capital is and depreciation is , the capital stock in the next period, , is . The net increment to the capital stock is the difference between gross investment and depreciation, and is called net investment.

Surplus value is a central concept in Karl Marx's critique of political economy. "Surplus value" is a translation of the German word "Mehrwert", which simply means value added, and is cognate to English "more worth". Surplus-value is the difference between the amount raised through a sale of a product and the amount it cost to the owner of that product to manufacture it: i.e. the amount raised through sale of the product minus the cost of the materials, plant and labour power. Conventionally, value-added is equal to the sum of gross wage income and gross profit income. However, Marx uses the term Mehrwert to describe the yield, profit or return on production capital invested, i.e. the amount of the increase in the value of capital. Hence, Marx's use of Mehrwert has always been translated as "surplus value", distinguishing it from "value-added". According to Marx's theory, surplus value is equal to the new value created by workers in excess of their own labor-cost, which is appropriated by the capitalist as profit when products are sold.

References

  1. Simon Kuznets, Gross capital formation, 1919-1933. New York: National Bureau of Economic Research, 1934.
  2. Raymond W. Goldsmith, A Perpetual Inventory of National Wealth. Studies in Income and Wealth, Vol. 14. New York: NBER, 1951, pp. 5-74.