When to Capitalize vs. Expense a Cost?
The Capitalize vs Expense accounting treatment decision is determined by an item’s useful life assumption.
Costs expected to provide long-lasting benefits (>1 year) are capitalized, whereas costs with short-lived benefits (<1 year) are expensed in the period incurred.
Capitalize vs. Expense Accounting Treatment
Capitalizing is recording a cost under the belief that benefits can be derived over the long term, whereas expensing a cost implies the benefits are short-lived.
Whether an item is capitalized or expensed comes down to its useful life, i.e. the estimated amount of time that benefits are anticipated to be received.
Generally, one useful question to ask is, “Will the cost continue to provide benefits for more than a year?”
- Yes? → Capitalize
- No? → Expense
If the anticipated useful life exceeds one year, the item should be capitalized – otherwise, it should be recorded as an expense.
- Capitalizing: The expenditure is recognized on the balance sheet as an asset, and then the asset is reduced by depreciation or amortization annually, which is an expense on the income statement.
- Expensing: The cost is recognized as an expense on the income statement in the same period as when the expense was incurred.
The term “capitalization” is defined as the accounting treatment of a cost where the cash outflow amount is captured by an asset that is subsequently expensed across its useful life.
The purpose of capitalizing a cost is to match the timing of the benefits with the costs (i.e. the matching principle).
Based on the useful life assumption of the asset, the asset is then expensed over time until the asset is no longer useful to the company in terms of economic output.
If an expenditure is capitalized, then it is either depreciated or amortized over time:
- Fixed Asset Purchase (PP&E) → Depreciation Expense
- Intangible Asset Purchase → Amortization Expense
On the other hand, if the purchase (and the corresponding benefit) is expected to be depleted within one year, it should be expensed in the period incurred.
Capitalize vs. Expense Examples
Capitalization Example (Capex and Depreciation)
The purchase of fixed assets (PP&E) such as a building — i.e. capital expenditures (CapEx) — is capitalized since these types of long-term assets can provide benefits for more than one year.
One of GAAP’s primary goals is to match revenue with expenses, so recording the entire CapEx at once would skew financial results and result in inconsistencies.
Suppose a company purchased a building for $2 million, and the expected useful life is 40 years.
Upon dividing CapEx by the useful life assumption, we arrive at $50k for the depreciation expense.
- Depreciation = $2 million / 40 years = $50k
Assuming a salvage value of zero, the initial $2 million carrying value of the PP&E would decline by $50k each year across the next 40 years until there is no balance.
However, the real cash outflow of $2 million is reflected on the cash flow statement (CFS) during the year of purchase.
Expense Example (Inventory Purchase)
For comparison, consider the purchase of inventory, which is cycled out fairly quickly in most cases, unless the company is very inefficient at working capital management.
Items that are expensed, such as inventory and employee wages, are most often related to the company’s day-to-day operations (and thus, used quickly).
The benefits are short-term (i.e. <1 year), thus the item should be expensed in the period of occurrence.
Hence, inventory is classified as a short-term asset, i.e. cleared out within one year.
Since the benefits are short-term, the purchase of inventory is recognized in accordance with the companies’ inventory accounting policies (i.e. FIFO vs LIFO), which is typically the same fiscal year as when the actual cash flow occurred.
Capitalize vs. Expense Examples
Capitalized Software Development Costs
Under GAAP, certain software costs can be capitalized, such as internally developed software costs.
The capitalized software costs are recognized similarly to certain intangible assets, as the costs are capitalized and amortized over their useful life.
The software development costs must meet GAAP’s criterion to be eligible to be capitalized.
Examples of capitalized software costs include the following:
- Compensation for Programmers Directly Associated with Software Development
- Internal Accounting Software
- Cash Management Tracking Software
- Customer Relationship Management (CRM)
- Purchased “Off-the-Shelf” Software
- 3rd Party Development Fees
Capitalize vs. Expense – Impact on Net Income
The effects of capitalizing a cost versus expensing a cost are as follows:
- Capitalizing → Higher Profitability in Initial Periods, Lower Profitability in Later Periods
- Expensing → Reduced Profitability in Initial Periods, Higher Profitability in Later Periods
Capitalized items that are depreciated (or amortized) rather than being expensed results in:
- Reduced Expenses
- Higher Net Income
But note that capitalizing an item for GAAP reporting purposes does not necessarily mean the same applies for tax reporting purposes, which can create a mismatch between tax and book values.
- If capitalized, the cash flow from investing activities section will capture the outflow.
- If expensed, the cash flow from operations will be lower (i.e. net income is the starting line item).
A company’s financial statements can be misleading if a cost is expensed as opposed to being capitalized, which is why management must disclose any changes to uphold transparency.
Moreover, the company’s near-term net income would be understated and be inflated for later periods because depreciation is not expensed.
ROA and ROE Impact – Capitalize vs. Expense
If a cost is capitalized instead of expensed, the company will show both an increase in assets and equity — all else being equal.
Early on, the company’s return on assets (ROA) and return on equity (ROE) are higher given the increased net income, i.e. the total cash outflow is spread across the useful life, rather than being expensed all at once.
But later on, the company’s return on assets (ROA) and return on equity (ROE) are lower because net income is higher with a higher assets (and equity) balance.
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