The cost of an item is allocated to the cost of an asset in accounting if the company expects to consume or use that item over a long period of time. The cost of the item or fixed asset is capitalized and amortized or depreciated over its useful life rather than being expensed.
Typical examples of corporatecapitalized costsinclude items of property, plant, and equipment. The cost wouldn't be expensed but would be capitalized as a fixed asset on the balance sheet if a company buys a machine, building, or computer.
Other expenses associated with constructing a fixed assetcan also be capitalized. They include materials, sales taxes, labor, transportation, and interest incurred to finance the construction of the asset. Intangible asset expenses such as trademarks, filing and defending patents, and software development can also be capitalized.
Key Takeaways
- A company effectively spreads costs out over time when it capitalizes them.
- This allows a company to avoid incurring a very large expense in the current period.
- Accounting rules and IRS regulations define which costs can be capitalized and which cannot.
- Costs that can be capitalized typically relate to assets that will generate revenue or value over time with their depreciation schedule matching the timing of their revenue generation.
- Intangible costs and certain types of labor can be capitalized in addition to fixed, tangible assets.
Understanding Capitalized Costs Within a Company
A company must derive economic benefit from assetsbeyond the current year and use the items in the normal course of its operations to be able to capitalize costs. Inventory can't be a capital asset because companies ordinarily expect to sell their inventories within a year.
Their effect on the company's income statement isn't immediate because capitalized costs are depreciated or amortized over a certain number of years. They're spread out throughout the asset's useful life. The cash effect from incurring capitalized costs is usually immediate with all subsequent amortization or depreciation expenses being non-cash charges.
Expenses that must be taken in the current period and cannot be capitalized include utilities, insurance, office supplies, and any item that's under a certain capitalization threshold. These are considered expenses because they're directly related to a particular accounting period.
Capitalized Costs for Fixed Assets
Companies often incur expenses associated with the construction of a fixed asset or putting it to use. These expenses are permitted to be capitalized and are included as part of the cost basis of the fixed asset.
The financing cost can be capitalized if a company borrows funds to construct an asset such as real estate and incurs interest expense. The company can also capitalize on other costs such as labor, sales taxes, transportation, testing, and materials used in the construction of the capital asset. Any subsequent maintenance costs must be expensed as incurred after the fixed asset is installed for use, however.
Capitalized Costs for Intangible Assets
Companies can capitalize costs associated with trademarks, patents, and copyrights. Capitalization is permitted for costs incurred to successfully defend or register a patent, trademark, or similar intellectual property. Companies can also capitalize on the costs they incur to purchase trademarks, patents, and copyrights.
They can capitalize on development costs for new software applications if they achieve technological feasibility which is attained after all necessary planning, coding, designing, and testing are complete. The software application satisfies its design specifications.
Current Expensing
Costs must be expensed immediately when a company can't demonstrate a link between costs and future revenues. Any associated costs incurred before achieving technological feasibility are expensed in the case of software development.
Research and development cost is another example of current expensing due to the high-risk profile and uncertainty of future benefits from such costs.
Each company's accounting department establishes its dollar-value threshold for what it considers an expense rather than a capitalizable cost.
What Is an Example of Capitalization in Accounting?
Let's say that a company purchases a large machine to add to an assembly line with a sticker price of $1 million. The company estimates that the machine's useful life is 10 years and that it will generate $250,000 per year in sales on average.
The company doesn't include the $1 million expense on its books in the year that it was purchased. It spreads out the capitalized cost over time according to a depreciation schedule.
What Expenses Should Be Capitalized Using GAAP?
Generally accepted accounting principles (GAAP) allow costs to be capitalized only if they have the potential to increase the value or extend the useful life of an asset.
What Is Capitalized Cost Reduction?
Capitalized cost reduction refers to mechanisms that lower the overall cost of the loan in the context of borrowing and lending. This typically comes in the form of an upfront down payment or mortgage points. A trade-in or cash rebate can also provide capitalized cost reduction for a car loan.
What Is Capitalized Labor?
Wage labor is usually expensed by a company as it's paid. Certain labor is allowed to be capitalized and spread out over time, however. This is typically labor that's identified as directly related to the construction, assembly, installation, or maintenance of capitalized assets.
This essentially attaches that specific labor expense to the capitalized asset itself. Common labor costs that you can capitalize include architects and construction contractors.
The Bottom Line
Cost and expense are two terms that are used interchangeably in everyday language but they're separate in accounting. A cost is an outlay of money to pay for a specific asset. An expense is money that's regularly used to pay for something. The difference allows capitalized costs to be spread out over a longer period, such as the construction of a fixed asset. The impact on profits is for a longer time frame.
