Cost Capitalization

What is Cost Capitalization?

Cost capitalization refers to the practice of not recognizing the cost of a fixed asset, tangible or intangible, in the period it was incurred but rather expensing it over a period of time through depreciation or amortization, respectively. Therefore, a capitalized cost can be recognized as a fixed asset rather than being expensed in the period incurred.

Cost capitalization is used when a business disburses finances to acquire an asset that is expected to be utilized over a long time. In other words, it counts as a cost incurred from the purchase of a fixed asset that is expected to directly produce economic benefit beyond a company’s normal operating cycle. If a cost is capitalized, it is expensed over time through amortization for intangible assets and depreciation for tangible assets. Cost capitalization often arises with the construction of buildings where construction costs and related interest costs can be capitalized. All expenses incurred to bring an asset to a condition where it can be used are capitalized as part of the asset. Such expenses may include but are not limited to installation costs, labor charges, and transportation costs. The Internal Revenue Service requires businesses to fully capitalize on business assets such as land, machinery, patents, and franchise rights.

The matching principle of accounting requires a business to match the cost of using an asset with the revenue it generates over its useful life. Cost capitalization allows a company to apply the matching principle.

Understanding Cost Capitalization

When businesses engage in cost capitalization, they are simply following the matching principle of accounting. This accounting principle seeks to recognize expenses in the same period as the related revenues. As a result, the goal of any business in cost capitalization is to match the cost of an asset to its periods of use when it is generating revenues instead of when the initial cost was incurred. The practice of cost capitalization meets the requirements of the matching principle where expenses are recognized at the same time that the revenues generated by those expenses are recognized.

Fixed assets such as machinery, factory buildings, and land do not generate any revenues when the costs are incurred. However, these long-term assets generate revenue over their entire useful life. It makes sense to recognize these costs over the asset’s useful life through depreciation or amortization over a long period to match the revenues generated from the assets.

The practice of cost capitalization involves depreciating or amortizing the asset over multiple years, which implies it will impact profits for multiple reporting periods into the future. It should be noted that the impact of the cash outflow from purchasing the fixed asset is immediate if paid for upfront. However, the depreciation or amortization relating to the asset is a non-cash expense. As a result, cost capitalization will cause a variation between the reported profit levels on the income statement and the associated cash flows reported on the cash flow statement. Capitalized costs are recorded on the balance sheet at their historical cost when incurred. The cash on the balance sheet reduces by the amount incurred while the fixed asset section increases by the same amount. Historical costs are a value measure that represents an asset at its original cost on the balance sheet but does not necessarily reflect the current fair value of the asset.

Example of Cost Capitalization

Take the simplified example of running a lemonade stand. The business decides to purchase a cutting-edge lemon squeezer. The machine will increase lemonade production and improve overall business efficiency.

The company will consider the cost of the machinery as a capitalized cost on its books. This is because including the entire cost in the income statement the year it is incurred would significantly impact the net income value. In addition, the piece of machinery will be used over several years. The cash expended on the lemon squeezer is not leaving the business with this purchase, it is retained in the equipment as a business asset or investment. Cost capitalization allows a company to recognize an expense as an asset. The money spent on the machine is not lost but locked up in the investment.

The cost of the machine is recorded on the balance sheet as an asset at its historical cost. Like every other asset, the value diminishes with time and use. The company, as a result, has to account for this through the use of depreciation on its income statement. With every passing year, the lemon squeezer machine loses some value. For example, if the business spent $2000 on the machine with a useful life of 10 years and a $500 salvage value at the end of that period. The depreciation expense related to the lemon squeezer will be $150 [($2000 historical cost – $500 salvage value) / 10 years]. The depreciation value of $150 will be recognized on the business’s income statement. The cash on the balance sheet will reduce by $2000, and the value of machinery will increase by $2000.

Importance and Drawbacks of Cost Capitalization

The primary goal of cost capitalization is to smooth out expenses over multiple periods. If a company employs cash-based accounting and acquires a piece of equipment, it will recognize a large cost in the year of the acquisition and therefore lower profits that year. However, it will receive the benefits from the equipment in the following years but no related costs are reflected in the financial statements. The financial statements will therefore not be reflective of the actual business activity.

Cost capitalization allows the company to smooth out the expenses over the useful life of the asset. By employing accrual-based accounting, there is no huge cash outflow in the first year, and the company will be able to present higher profits than it would have had if it expensed the cost in full. The company will recognize an asset that depreciates over the life of the equipment and match these expenses with the revenues generated over time.

Cost capitalization and depreciation depend on varying estimates and assumptions. It can mislead investors regarding the profit margins of a business. Company management may choose to capitalize on more costs in order to manipulate the financial statements in a way that presents misleading information about a company’s figures. This is a genuine drawback of cost capitalization.

Conclusion

Cost capitalization can be used for tangible and intangible assets. It allows businesses to recognize significant expenses as assets on the balance sheet. However, the asset loses value over time, and as such, businesses must use non-cash expenses such as depreciation or amortization to account for the loss of value. This helps firms smooth out expenses over multiple periods and provide more informative financial statements. On the other hand, because cost capitalization and depreciation rely on estimates and assumptions, unscrupulous management can use them to influence the figures and profitability of a business to make it look more attractive to investors.

Below is a multiple-choice question to test your knowledge. Download the Excel exercise sheet attached to find a full explanation of the correct answer.