Capitalized CostExplained & Defined

Lisa Borga

What are Capitalized Costs?

Capitalized cost is an organization’s cost in purchasing and financing certain assets.

Capitalized assets, including any expenses incurred in acquiring them, are added as an asset to the balance sheet.

Capitalized costs are not expensed in the period in which they are incurred.

Instead, they will be recognized over multiple periods through deductions such as depreciation, depletion, and amortization.

capitalized costs

How to Understand Capitalized Costs

When a company incurs a typical expense, it is placed in the appropriate account and is assumed to be incurred in the period in which it was used.

This follows the requirement of the matching principle  in accounting, which states that expenses should be recognized in the same period as the revenues which they helped to generate.

However, it is not so simple when certain long-term assets are acquired.

Assets such as machinery or facilities may help to generate revenue for many years before they wear down.

This means that if a piece of factory equipment has a useful life of 20 years during which it helps to generate revenue, its cost should be recognized throughout the same 20 year period, and this is what capitalization helps to accomplish.

A capitalized cost is typically depreciated or amortized over multiple accounting periods over the useful life of the asset.

Though the cash flow for the asset will be performed immediately, the capitalized cost will only be recognized and reduce profits over future periods.

These future depreciation or amortization expenses will be non-cash and, as a result, will cause reported profit recorded on the income statement to fail to match the cash flows recorded on the statement of cash flows.

There are many different types of assets that can be capitalized, including the most common examples, which are equipment, plants, property, and the expenses associated with acquiring them.

This means that materials, labor, and the sales taxes incurred in acquiring a fixed asset can be capitalized in addition to the asset itself.

Another common type of asset which can be capitalized is intangible assets such as trademarks, copyrights, and patents.

Capitalizing the Cost of Software Development

Another cost that can be capitalized is software development.

There are three phases of software development, but a business can only capitalize the costs that occur in the application development stage.

As an example, a business could capitalize costs, such as data conversion costs, employee pay, employee bonuses, as well as debt insurance costs.

However, these costs would only be allowed to be capitalized if the project would require more testing before it was applied.

capital investment

Capitalized Cost Example

For an example of capitalized costs, consider a bakery.

The bakery would need to acquire a building and adapt it as needed, purchase ovens and other necessary bakery equipment, and install the equipment.

Additionally, a bakery would need to purchase the necessary ingredients for the baked goods, such as flour, sugar, butter, and other necessary ingredients.

The bakery owner would also have to pay any employees that they hire to bake and sell their baked goods.

Additional costs for the bakery would be any advertising or marketing the bakery chooses to do in order to promote their product, as well as any other costs such as sales or distribution costs.

Some items would be recorded as expenses in the company general ledger, such as employee wages, window cleaning, utilities, and other costs that fail to reach the capitalization threshold.

Items such as these are recorded as expenses due to the fact that they are specifically associated with a specific accounting period.

Other items might also be recorded as an expense due to their low cost, even though they may be used for several periods.

Examples of this would include a cake display stand for $60 and a bread slicer for $112.

Every company will have its own threshold for what it will record as an expense instead of a capitalized cost.

The bakery would capitalize the costs of its ovens, professional mixers, bagel toasters, and other expensive equipment.

When the company purchases these items, the value will be retained by the equipment as an asset of the business.

The business is also allowed to capitalize the costs associated with the equipment, such as shipping and installation.

The taxes on the equipment may also be capitalized.

All of these expenses were necessary to acquire the equipment and get it ready for use.

When capital costs are first recorded on the company’s balance sheet, they are recorded at their historical cost.

The capital costs will then be moved from the company’s balance sheet to its income statement, where they will be expensed either through depreciation or through amortization.

An example of this would be the bakery’s convection oven.

The oven cost $15,000 and has an estimated useful life of seven years with a $1,000 salvage value at the end of the seven years.

This means the depreciation expense for the convection oven would be $2,000 per year.

$15,000 historical cost – $1,000 salvage value/7 years useful life = $2,000 depreciation per year

Pros and Cons of Capitalized Costs

capital expenditure

By capitalizing assets with a high dollar value, the expense can be spread out over a period of time.

By doing this, a business can avoid large increases in their expenses in a particular period from the purchase of high-priced assets such as a building, equipment, or land.

This will allow a business to report higher profits in the period in which the asset was purchased, but the business will be required to pay more taxes as well.

If a business capitalizes costs inappropriately, it can cause investors to believe that the business has a higher profit margin than it actually does.

There are some indicators that investors can look for to see if a business is capitalizing its costs inappropriately, such as:

  • A rapid increase in the number of fixed or intangible assets being recorded in a company’s financial records
  • Unexpectedly high-profit margins occurring at the same time as an increased drop in free cash flow
  • Increasing capital expenditures

What are Some Advantages of Capitalizing Costs?

If a company capitalizes some of its costs, it will have more cash flow by allowing the company to spread out some of its expenses over several quarters.

This will help the company by enabling it to avoid reporting several large expenses in a single year.

Are there Disadvantages to Capitalizing Costs?

There are some potential disadvantages to capitalizing costs, such as possible increases in tax bills, misleading investors as to the business’s profit margins, and a decrease in free cash flow.

What Costs Can Be Capitalized?

A business can only capitalize an asset if it expects to continue to benefit from the asset after the current year.

Companies can capitalize the costs associated with intangible assets, such as trademarks, patents, or copyrights.

Costs such as labor, testing, transportation, and sales taxes may also be capitalized.

Key Takeaways

  • When a company capitalizes, the cost of a fixed asset has not left the company despite any cash outflows. This is because the acquired asset retains the value spent on it.
  • A capitalized cost will be expensed over multiple periods instead of the one in which the acquisition was made.
  • Capitalized costs allow a company to gain a clearer idea of how the cost of an asset aligns with the revenue it generates.
  • Most companies establish a threshold of value that must be reached before they will consider capitalizing on a cost.

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  1. Cornell Law School "Capitalized Expenditure" Page 1 . January 31, 2022

  2. University of Iowa "What costs can be capitalized?" Page 1 . January 31, 2022

  3. IRS.gov "Section 263.–Capital Expenditures" Part 1 - section 263. January 31, 2022