In accounting, the cost of an item is allocated to the cost of an asset, as opposed to being an expense, if the company expects to consume that item over a long period of time. Rather than being expensed, the cost of the item or fixed asset is capitalized and amortized or depreciated over its useful life.
Typical examples of corporatecapitalized costsare items of property, plant, and equipment. For example, if a company buys a machine, building, or computer, the cost would not be expensed but would be capitalized as a fixed asset on the balance sheet.
Other expenses associated with constructing a fixed assetcan also be capitalized. These include materials, sales taxes, labor, transportation, and interest incurred to finance the construction of the asset. Intangible asset expenses can also be capitalized, such as trademarks, filing and defending patents, and software development.
Key Takeaways
- When a company capitalizes costs, it effectively spreads them out over time.
- 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 can be capitalize 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 are allowed to be capitalized in addition to fixed, tangible assets.
Understanding Capitalized Costs Within a Company
To capitalize cost, a company must derive economic benefit from assetsbeyond the current year and use the items in the normal course of its operations. For example, inventory cannot be a capital asset since companies ordinarily expect to sell their inventories within a year.
Because capitalized costs are depreciated or amortized over a certain number of years, their effect on the company's income statement is not immediate and, instead, is spread out throughout the asset's useful life. Usually, the cash effect from incurring capitalized costs is immediate with all subsequent amortization or depreciation expenses being non-cash charges.
Expenses that must be taken in the current period (they cannot be capitalized) include Items like utilities, insurance, office supplies, and any item under a certain capitalization threshold. These are considered expenses because they are 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. Such expenses are allowed to be capitalized and included as part of the cost basis of the fixed asset.
If a company borrows funds to construct an asset, such as real estate, and incurs interest expense, the financing cost is allowed to be capitalized. Also, the company can capitalize on other costs, such as labor, sales taxes, transportation, testing, and materials used in the construction of the capital asset. However, after the fixed asset is installed for use, any subsequent maintenance costs must be expensed as incurred.
Capitalized Costs for Intangible Assets
Companies are allowed to capitalize costs associated with trademarks, patents, and copyrights. Capitalization is allowed only for costs incurred to defend or register a patent, trademark, or similar intellectual property successfully. Also, companies can capitalize on the costs that they incur to purchase trademarks, patents, and copyrights.
Companies are allowed to capitalize on development costs for new software applications if they achieve technological feasibility. Technological feasibility is attained after all necessary planning, coding, designing, and testing are complete, and the software application satisfies its design specifications.
Current Expensing
When a company cannot demonstrate a link between costs and future revenues, such costs must be expensed immediately. In the case of software development, any associated costs incurred prior to achieving technological feasibility are expensed. 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?
Say that a company purchases a large machine to add to an assembly line with a sticker price of $1 million. The company estimates its useful life is 10 years and that it will generate, on average, $250,000 per year in sales. As a result, the company does not include the $1 million expense on its books in the year that it was purchased; rather, it spreads out the capitalized cost over time according to a depreciation schedule.
What Expenses Are Supposed Be Capitalized Using GAAP?
Generally accepted accounting principles, or GAAP, allows costs to be capitalized only if they have the potential to increase the value or can extend the useful life of an asset.
What Is Capitalized Cost Reduction?
In the context of borrowing and lending, capitalized cost reduction refers to mechanisms that lower the overall cost of the loan. Typically, this comes in the form of an upfront down payment or mortgage points. For a car loan, a trade-in or cash rebate can also provide capitalized cost reduction.
What Is Capitalized Labor?
Most often, wage labor is expensed by a company as it is paid. However, certain labor is allowed to be capitalized and spread out over time. This is typically labor that is identified as directly related to the construction, assembly, installation, or maintenance of capitalized assets. This essentially attaches that specific labor expense with the capitalized asset itself. Common labor costs that you are capitalized include architects and construction contractors.
The Bottom Line
Cost and expense are two terms that are used interchangeably in everyday language. However, in accounting, the two terms are separate. A cost is an outlay of money to pay for a specific asset, whereas an expense is the money used to pay for something regularly. The difference allows for capitalized costs to be spread out over a longer period, such as the construction of a fixed asset, and the impact on profits is for a longer time frame.
