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 corporate capitalized costs are expenses associated with constructing a fixed asset and can include materials, sales taxes, labor, transportation, and interest incurred to finance the construction of the asset. Expenses associated with intangible assets can also be capitalized; these include trademarks, filing and defending of patents, and software development.
To capitalize cost, a company must derive economic benefit from assets beyond 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.
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.
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.
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 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.