Testimony: Mr. Swanson described capital budgeting in the private sector. He discussed three aspects of the private sector's capital budgeting process: 1) definition of capital budgeting; 2) ranking of capital projects based on return and risk; and 3) funding of capital projects.
He said capital budgeting is an element of the strategic planning process in a firm. Accordingly, he defined capital budgeting as balancing capital spending choices (projects) against available funding. He said companies typically establish an objective definition of capital expenditures in accordance with Generally Accepted Accounting Principles (GAAP), because differentiating capital and operating expenditures is vague. GAAP defines capital expenditures as any expenditure that are capitalized in the books. Exceptions to this rule include research and development and software development costs, which are generally expensed under GAAP.
He said the capital budgeting process is a ranking exercise. He said candidate projects are ranked based on risk and return, and a "cut-off point" is determined based on available funding or financial performance threshold. He referred to finance textbooks on methodologies for determining financial returns, and noted that analyses used by companies vary. He discussed risk considerations in prioritizing projects, and how companies reduce risks.
He described how funding limits capital expenditures. He recognizes, in theory, that vast and liquid capital markets do not constrain financially attractive capital projects, because investors would invest in any project expected to earn more than its cost of capital. He said in this situation, there would be no capital "budget" per se, just an analytical effort to determine which project will exceed the cost of capital threshold. However, in reality, most firms consider that capital is a scare resource, and limit capital expenditures to meet target debt-equity ratios and dividend policies.
Questions from the Commissioners: The questions focused on the applicability of the private sector capital budgeting principals to the Federal government.
Q. Is the definition of capital not standardized?
A. From an accounting point of view, the definition is standard. However, capital budgeting really involves how companies make decisions, so the companies decide how to make investment decisions based on their specific situation without confining themselves to accounting definitions.
Q. What principals in the private sector could apply
to the Federal government?
A. Over the long run, in a steady state, the Federal government's annual capital expenditures would tend to equal annual depreciation. Under these circumstances, the ability of the accounting system to differentiate between capital and operating expenditures, and to explicitly recognize depreciation as a periodic cost, would not be critical. Over shorter periods, particularly if the political process were to lead to an un-even pattern of expenditures, or net shrinkage or growth in the overall capital stock, the equality between capital expenditures and depreciation would not occur. In this case, an accounting system which explicitly recognizes the difference between capital expenditures and operating expenditures, as well as depreciation expense as a component of the annual budget, would be an important tool for sound decision making.