What is 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 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.
Breaking Down Capitalized Cost
Capitalizing cost 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 a capitalized cost is, it’s first important to make the distinction between what is defined as a cost and an 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 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 of Capitalized Cost
For example, let's 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 its laborers 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 books would include rent on the space, utilities, pest control, 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 an 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 relatively low cost. Each company has its own threshold for what it considers a cost or an expense.
The roasting facility’s packaging machine, its 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 costs of a shipping container, transportation from the farm, taxes, and freight delivery to the roasting facility could also be considered part of the capitalized cost. "Attic stock" or leftover material from construction, such as carpet, wallpaper, and floorboards can also be considered a capitalized cost.
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 $15,000 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 the 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, however, over a longer period of time the differences in the cost of taxes makes no real difference. Firms that tend to expense a cost instead of capitalizing will have somewhat lower stockholders' 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 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.
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 a rapidly growing asset on the books are all warning signs that a company is capitalizing costs inappropriately.