What Is a Capitalized Cost?
A capitalized cost is an expense that is added to the cost basis of a fixed asset on a company's balance sheet. Capitalized costs are incurred when building or purchasing fixed assets. Capitalized costs are not expensed in the period they were incurred but recognized over a period of time via depreciation or amortization.
- With capitalized costs, the monetary value isn’t leaving the company with the purchase of an item, as it is retained in the form of a fixed or intangible asset.
- Capitalized costs are depreciated or amortized over time instead of being expensed immediately.
- The purpose of capitalizing costs is to better line up the cost of using an asset with the length of time in which the asset is generating revenue.
Understanding Capitalized Costs
When capitalizing costs, a company is following the matching principle of accounting. The matching principle seeks to record expenses in the same period as the related revenues. In other words, the goal is to match the cost of an asset to the periods in which it is used, and is therefore generating revenue, as opposed to when the initial expense was incurred. Long-term assets will be generating revenue over the course of their useful life. Therefore, their costs may be depreciated or amortized over a long period of time.
For example, expenses incurred during construction of a warehouse are not expensed immediately. The costs associated with building the warehouse, including labor costs and financing costs, can be added to the carrying value of the fixed asset on the balance sheet. These capitalized costs will be expensed through depreciation in future periods, when revenues generated from the factory output are also recognized.
Example of Capitalized Cost
Assume the warehouse in the above example was a coffee roasting facility. Some of the likely costs of building and operating a roasting facility are customization of the interior for the specifics of the business, purchase of roasting and packing equipment, and equipment installation costs. In addition to the machinery and hardware, the company would need to purchase green coffee (inventory) to roast. It also needs to pay its employees to roast and sell that coffee. Further costs would include marketing and advertising their product, sales, distribution, and so on.
Items that would show up as an expense in the company’s general ledger include utilities, pest control, employee wages, and any item under a certain capitalization threshold. These are considered expenses because the value of running water, no bugs, and operational staff can be directly linked to one accounting period. Certain items, like a $200 laminator or a $50 chair, would be considered an expense because of their relative low cost, even though they may be used over multiple periods. Each company has its own dollar value threshold for what it considers an expense, rather than a capitalizable cost.
The roasting facility’s packaging machine, roaster, and floor scales would be considered capitalized costs on the company’s books. The monetary value isn’t leaving the company with the purchase of these items. When the roasting company spends $40,000 on a coffee roaster, the value is retained in the equipment as a company asset. The price of shipping and installing equipment is included as a capitalized cost on the company’s books. The costs of a shipping container, transportation from the farm to the warehouse, and taxes could also be considered part of the capitalized cost. These expenses were necessary to get the building set up for its intended use.
Capitalized costs are originally recorded on the balance sheet as an asset at their historical cost. These capitalized costs move from the balance sheet to the income statement as they are expensed through either depreciation or amortization. For example, the $40,000 coffee roaster from above may have a useful life of 7 years and a $5,000 salvage value at the end of that period. Depreciation expense related to the coffee roaster each year would be $5,000 (($40,000 historical cost - $5,000 salvage value) / 7 years).
Advantages and Disadvantages of Capitalized Costs
When high dollar value items are capitalized, expenses are effectively smoothed out over multiple periods. This allows a company to not present large jumps in expense in any one period from an expensive purchase of property, plant, or equipment. The company will initially show higher profits than it would have if the cost was expensed in full. However, this also means that it will have to pay more in taxes initially.
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 (FCF), increases in capital expenditures, and rapidly growing fixed or intangible assets recorded on the books are all warning signs that a company may be capitalizing costs inappropriately.
Capitalizing Software Development Costs
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 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 additional testing before application.