Capitalized Cost

AAA

DEFINITION of 'Capitalized Cost'

An expense that is added to the cost basis of a fixed asset on a company's balance s​heet. Capitalized costs are incurred when building or financing fixed assets. Capitalized costs are not expensed in the period they were incurred, but recognized over a period of time via depreciation or amortization.

INVESTOPEDIA EXPLAINS 'Capitalized Cost'

Capitalizing costs is a method of following the matching principle of accounting. The matching principle seeks to match expenses with revenues. In other words, match the cost of an item to the period in which it is used, as opposed to when the cost was incurred. As some assets have long lives and will be generating revenue during that useful life, their costs may be amortized over a long period.

An example of where assets would and would not be capitalized can be found in the construction and operation of a warehouse. The costs associated with building the asset (including labor and financing costs) can be added to the carrying value of the fixed asset on the balance sheet. These capitalized costs will be recognized in future periods, when revenues generated from the factory output are recognized.

Cost vs. Expense

When trying to discern what is a capitalized cost, it’s first important to make the distinction between what is defined as a cost and expense in the world of accounting. A cost on any transaction is the amount of money used in exchange for an asset. A company buying a forklift would mark such a purchase down as a cost. An expense is monetary value leaving the company, this would include something like paying the electricity bill or rent on a building.

Example

Lets say that the warehouse in the above example was a coffee roasting facility. Some of the likely costs and expenses of building and operating a roasting facility will be paying rent on the building, customizing the interior for the specifics of the business, purchasing roasting and packing equipment, and then having that equipment installed. In addition to the machinery and hardware, the company would need to purchase green coffee (inventory) to roast, as well as pay it's laborers to roast and sell that coffee, in addition to the costs of marketing and advertising their product, sales, distribution and so on.

Items that would show up as an expense in the company’s books would include rent on the space, utilities, pest control, the opening party at the end of construction, wages paid to the labor operating the site once it’s operational, and anything under a certain price threshold. These are all considered expenses because the value of having use of a building, no bugs, running water, and an operational staff is being paid for, but not retained after the pay period expires. If the water bill isn’t paid, the roasting facility has no water. As for the opening party, because it's after the project was finished, it wouldn't be added to the overall cost of building the warehouse. Certain items, like a $200 laminator or a $50 chair, would be considered an expense because of its relative low cost. Each company has it’s own threshold for what they consider a cost or an expense.

The roasting facility’s packaging machine, it’s roaster, floor scales, green coffee inventory, and lunches are all items that would be considered capitalized costs on the company’s books. The monetary value isn’t leaving the company with these purchases. When the roasting company spends $130,000 on a coffee roaster and another $10,000 on green coffee beans, the value is retained in the equipment and beans as company assets.

Lunches would be included as a capitalized cost because they were a part of the project cost. The same logic is applied to the inclusion of the price of shipping and installation of equipment as costs on the company’s books. The cost of a shipping container, transportation from the farm, taxes, and freight delivery to the roasting facility could also considered part of the capitalized cost. "Attic stock" or leftover material from construction (for instance, carpet, wallpaper and floor-boards) can also be considered a capitalized cost.

These assets would then be recorded as either current assets or long term assets on the companies balance sheet valued at their historical cost, meaning their original price.

These capitalized costs move off of the balance sheet as they are eventually ‘expensed’ either through depreciation or amortization. When the green coffee is roasted and then sold at $15,000, the original cost of the beans is marked down as an expense of $10,000 at the same time that that 15,000 dollar revenue and 5,000 profit is recorded. For a piece of equipment like a roaster, the cost can be expensed over a period of time that reflects the depreciation of value of the roaster.

The benefit of capitalizing costs is that over a period of time a company will show higher profits than it would have otherwise, this may mean that they’ll have to pay higher taxes than if they expensed a cost. When it comes to taxes though - over a longer period of time the differences in cost of taxes makes no real difference. Firms that tend to expense a cost instead of capitalizing will have somewhat lower stockholder equity but will ultimately make no difference for a shareholder.

Capitalizing Software Development Costs

As Stanford University defines it, out of the three phases of software development, Preliminary Project Stage, Application Development Stage, and Post-Implementation/Operation Stage, only the costs from the application development stage should be capitalized. Examples of the costs a company would capitalize would include salaries of employees working on the project, their bonuses, debt insurance costs, and costs of data conversion from old software. These costs could be capitalized only as long as the project would need new testing before application.

Misuse

Capitalizing costs inappropriately can lead investors to believe that a company’s profit margins are higher than they really are. Surprising or unrealistic profit margins combined with sudden drops in free cash flow, increases in capital expenditures, and a rapidly growing asset on the books be a warning signs that a company is capitalizing costs inappropriately. 

 

VIDEO

Loading the player...
RELATED TERMS
  1. Amortization

    1. The paying off of debt in regular installments over a period ...
  2. Interest Expense

    The cost incurred by an entity for borrowed funds. Interest expense ...
  3. Capitalize

    An accounting method used to delay the recognition of expenses ...
  4. Accrued Interest

    1. A term used to describe an accrual accounting method when ...
  5. Capitalized Lease Method

    An accounting approach that identifies a company's lease obligation ...
  6. Income Statement

    A financial statement that measures a company's financial performance ...
RELATED FAQS
  1. What are typical examples of capitalized costs within a company?

    Typical examples of capitalized costs are expenses associated with constructing a fixed asset and include materials, sales ... Read Full Answer >>
  2. What is fair capital?

    So-called "fair capital," like beauty, is in the eye of the beholder. In financial reporting, there are two kinds of capital: ... Read Full Answer >>
  3. What are some examples of general and administrative expenses?

    In accounting, general and administrative expenses represent the necessary costs to maintain a company's daily operations ... Read Full Answer >>
  4. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  5. How do dividend distributions affect additional paid in capital?

    Whether a dividend distribution has any effect on additional paid-in capital depends solely on what type of dividend is issued: ... Read Full Answer >>
  6. Why can additional paid in capital never have a negative balance?

    The additional paid-in capital figure on a company's balance sheet can never be negative because companies do not pay investors ... Read Full Answer >>
Related Articles
  1. Fundamental Analysis

    Explaining Capitalized Cost

    A capitalized cost is an expense associated with a fixed asset that is added to the basis of that asset and expensed over its depreciable life.
  2. Investing Basics

    The Working Capital Position

    Learn how to correctly analyze a company's liquidity and beat the average investor.
  3. Mutual Funds & ETFs

    Introduction To Fundamentally Weighted Index Investing

    If you believe the market smiles on those who focus on value, growth or income, this vehicle may be for you.
  4. Markets

    Intangible Assets Provide Real Value To Stocks

    Intangible assets don't appear on balance sheets, but they're crucial to judging a company's value.
  5. Fundamental Analysis

    Taking Stock Of Discounted Cash Flow

    Learn how and why investors are using cash flow-based analysis to make judgments about company performance.
  6. Credit & Loans

    Debt Ratios

    Learn about the debt ratio, debt-equity ratio, capitalization ratio, interest coverage ratio and the cash flow to debt ratio.
  7. Professionals

    Are Stock Buybacks Always Good for Shareholders?

    Stock buyback programs aren't always done with the interests of shareholders in mind. It's important to try to understand the motivation behind such moves.
  8. Fundamental Analysis

    Making Sense of Netflix's Balance Sheet

    Understand how to assess Netflix's performance based on the major components of its balance sheet.
  9. Economics

    Understanding the Top Line

    Top line refers to a company’s gross sales without any reductions for discounts or returns.
  10. Economics

    What's an Allowance for Doubtful Accounts?

    The allowance for doubtful accounts represents the percentage of the accounts receivable the company expects to write-off as uncollectible.

You May Also Like

Hot Definitions
  1. Dog And Pony Show

    A colloquial term that generally refers to a presentation or seminar to market new products or services to potential buyers.
  2. Topless Meeting

    A meeting in which participants are not allowed to use laptops. A topless meeting organizer can also ban the use of smartphones, ...
  3. Hedging Transaction

    A type of transaction that limits investment risk with the use of derivatives, such as options and futures contracts. Hedging ...
  4. Bogey

    A buzzword that refers to a benchmark used to evaluate a fund's performance. The benchmark is an index that reflects the ...
  5. Xetra

    An all-electronic trading system based in Frankfurt, Germany. Launched in 1997 and operated by the Deutsche Börse, the Xetra ...
  6. Nuncupative Will

    A verbal will that must have two witnesses and can only deal with the distribution of personal property. A nuncupative will ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!