A capitalized cost is an expense added to the cost basis of a fixed asset on a company’s balance sheet. Capitalized costs are incurred when building or purchasing fixed assets. Instead of being expensed immediately during the period they were incurred, they’re recognized over time through depreciation or amortization.
Key Takeaways
- With capitalized costs, the monetary value remains within the company in the form of a fixed or intangible asset.
- Capitalized costs are depreciated or amortized over time rather than being expensed immediately.
- The goal of capitalizing costs is to align the cost of an asset with the period during which the asset generates revenue.
- Each company typically has a threshold value that determines what is considered an expense versus a capitalizable cost.
- In certain situations, employee salaries and bonuses can be capitalized.
Mastering Capitalization: A Look at Accounting Principles
When a company capitalizes costs, it follows the matching principle of accounting. This principle mandates recording expenses in the same period as the revenue they generated. The intent is to link the cost of an asset to the periods during which it is utilized to generate revenue, not just when the expenditure occurred.
Long-term assets are expected to produce revenue throughout their useful lives. Thus, their costs are depreciated or amortized over lengthy periods. According to the Internal Revenue Service, various business assets, including land, buildings, furniture, machinery, vehicles, and installation costs, must be capitalized. Examples include patents and franchise rights as well.
Cost Capitalization During Construction
For instance, costs incurred during the construction of a warehouse aren’t expensed immediately. Construction expenses such as labor and financing costs are added to the carrying value of the fixed asset on the balance sheet. These capitalized costs are then expensed via depreciation in future periods, aligned with the revenue generated by the warehouse.
Software Development as a Capitalized Cost
In software development, capitalized costs apply only to the application development stage. Expenses during phases like the preliminary project stage and post-implementation are not capitalized. For example, costs such as employee salaries, bonuses, debt insurance costs, and data conversion related to the project can be capitalized, provided they arise during the application development phase.
Real-World Example: Capitalizing Costs in a Coffee Roasting Facility
Consider a coffee roasting facility. The major costs associated with setting up the operation could include customizing the facility, buying roasting and packing equipment, and installation. Additionally, the company needs to purchase green coffee beans and pay employees for roasting and selling the products. Other expenses include marketing, sales, and distribution.
Items appearing as expenses in the company’s general ledger might include utilities, pest control, and employee wages, all of which are directly linked to a single accounting period. Relatively inexpensive items like a $200 laminator or a $50 chair are considered expenses due to their low cost, even if used over multiple periods.
Costs like the roasting facility’s packaging machine, roaster, and floor scales are considered capitalized costs. The value of these items is retained within the company as assets. Related expenses for shipping and installation are also included as capitalized costs. These expenses were necessary to set up the facility for its intended use.
Originally recorded on the balance sheet at their historical cost, capitalized costs move to the income statement and are expensed through depreciation or amortization. If a $40,000 coffee roaster has a useful life of seven years and a $5,000 salvage value, the annual depreciation expense would be $5,000 [($40,000 historical cost - $5,000 salvage value) / 7 years].
Balancing Act: The Pros and Cons of Capitalized Costs
Advantages:
- Smoothing of expenses over periods which prevents financial spikes.
- Initial higher profits as the costs are spread out.
- Improved cash flow management with delayed expense recognition.
Disadvantages:
- Potential to mislead investors regarding profit margins.
- Initial higher tax liability.
- Drop in free cash flow is challenging.
Identifying Inappropriate Capitalization
Signs that a company may be wrongly capitalizing costs include:
- Unsustainable profit margins.
- Sudden dips in free cash flow.
- Rising capital expenditures and the increase of tangible or intangible assets on the books.
Maximizing Capitalization
Intangible assets like patents, software development costs, and trademarks can be capitalized. Additionally, costs associated with transportation, labor, sales taxes, and materials can also be included as capitalized costs.
Related Terms: balance sheet, capital expenditures, fixed assets, depreciation, amortization.
References
- Accounting Tools. “Capitalized Cost Definition”.
- Internal Revenue Service. “Publication 535, Business Expenses”, Page 4.
- Internal Revenue Service. “Publication 535, Business Expenses”, Page 25.
- Internal Revenue Service. “Publication 535, Business Expenses”, Pages 4, 20, 31-32.
