Definition
Capitalization and expensing are two different methods used by companies to record their expenditures. Capitalization involves spreading out the cost of a big-ticket item over its useful life, which shows up on the balance sheet as a long-term asset. On the other hand, expensing is when companies immediately charge off smaller expenses or costs related to routine operations, directly affecting the income statement as an immediate expense.
Key Takeaways
- Capitalization is a method in which expenses related to the acquisition or improvement of long-term assets, such as property, plant, and equipment, are spread out over the asset’s useful life. These expenses are carried on the balance sheet as assets.
- Expensing, on the other hand, is a method where costs are immediately reported and deducted in the income statement in the period the expense is incurred. These are generally used for short-term operational expenses.
- The choice between capitalization and expensing can have significant impact on a company’s financial statements. Capitalization can boost a company’s short-term earnings as the expenditure is not immediately recognized in full. Expensing tends to depress short-term profitability but provides tax benefits. The decision generally depends on the nature of the expenses and compliance with accounting principles.
Importance
Capitalization and expensing are significant methods of accounting for business costs that greatly influence a company’s profitability and fiscal health on paper. Capitalization involves spreading out the cost of a big-ticket item, like machinery or a building, over its useful life, allowing the company to gradually write off the cost rather than all at once.
This method smoothes the company’s earnings over time. On the other hand, expensing means deducting all the cost in the year the expense occurred, which can lead to fluctuations in the company’s reported earnings.
These methods have distinct tax implications as well. The choice between capitalization and expensing can impact both a company’s short-term and long-term financial pictures and therefore plays a critical role in financial planning and analysis.
Explanation
Capitalization and expensing are integral financial concepts needed to adhere to the principles of accrual accounting and to maintain consistency and accuracy in financial reporting. The primary purpose of capitalization is to spread the cost of an asset over its useful lifespan. It involves recording a cost as an asset, rather than an expense.
Capitalization allows a company to match the cost of an asset, such as equipment or property, with the income it generates over its usable life. This way, rather than recording the entire cost of the asset at the time of purchase, the cost is spread out over its expected lifespan which in turn reduces the impact on earnings in the initial purchase period. On the other hand, expensing is used for costs that will not generate future economic benefits or whose future benefits do not meet the strict criteria for capitalization.
It means recording a cost as an immediate expense, reducing the company’s net income for the period during which the cost was incurred. The purpose of expensing is to accurately match income with expenses occurred to generate that income within the same accounting period. This approach ensures the company’s revenues and resources are not overstated, providing a more accurate depiction of financial health.
It’s also used for smaller purchases or when the useful life of the item does not meet a certain threshold set by the company or by accounting standards.
Examples of Capitalization vs Expensing
Buying Office Equipment: A company might purchase office equipment like computers, printers, and desks. The total cost of these items can be viewed in two ways: as a capital asset or as an expense. If the equipment is treated as a capital asset, it is capitalized, and the cost is spread out over the useful life of those assets, which could be several years. This means each yearly balance sheet will only contain a portion of the original cost, that is the depreciation. But if the equipment is expensed, the full cost is recognized immediately in the year of purchase causing a drastic decrease in the profits of that year.
Construction Costs: A real estate company building a complex incurs a lot of costs such as land purchase, construction materials and labour etc. If capitalized, the total cost becomes the basis for the value of the complex. As the complex is depreciated over its useful life, a fraction of this total cost appears as depreciation expense each year. If all construction costs were expensed, the company would show a large loss in the year of construction (even if construction spans several years) despite owning a valuable asset at the end of construction, which can distort the company’s true financial situation.
Research and Development Cost: A pharmaceutical company that’s investing in research and development (R&D) for a new drug. If the company capitalizes these R&D costs, they’re treated as an asset and gradually expensed over the future periods where the benefits (sales of the new drug) are expected to be achieved. If expensed outright, the entire cost is reported on the income statement in the period incurred, significantly reducing that year’s profits. However, rules about capitalizing R&D costs differ between countries and accounting standards; in some cases, R&D costs must be expensed.
FAQs on Capitalization vs Expensing
What is Capitalization in Finance?
Capitalization, in finance, refers to the process of recording a cost/expense on the balance sheet for the purposes of delaying full recognition of the expense in the income statement. Cost incurred in order to acquire an asset, upgrade an existing asset, or extend its useful life, are typically capitalized.
What is Expensing in Finance?
Expensing is the process of immediately charging off or writing down an expense in the income statement. These are costs that cannot be capitalized, and are usually routine in nature or for supplies or services used in the regular course of business.
What is the main difference between Capitalization and Expensing?
The main difference between capitalization and expensing lies in the timing of when the cost is recognized. Capitalized expenses are recognized over a period of time as depreciation, while expensed costs are recognized immediately in the period they occur.
Why is the decision to capitalize or expense important?
The decision to capitalize or expense an item has a direct impact on the income statement. Expensing results in immediate decrease in earnings, while capitalizing allows a company to spread out the recognition of the expense over the useful life of the asset, thereby reducing the immediate impact on earnings.
What are some examples of costs that are capitalized or expensed?
Capitalized expenses can include costs related to acquiring or improving a long-term asset, like plant, property, or equipment. On the other hand, routine maintenance or repair costs for an asset are typically expensed.
Related Entrepreneurship Terms
- Asset Depreciation: The gradual decrease in the value of a capital asset over its useful life.
- Capital Expenditures (CapEx): Funds used by a company to acquire or upgrade physical assets such as equipment, property, or industrial buildings.
- Operating Expenses (OpEx): The expenses a business incurs through its normal business operations.
- Income Statement: A financial statement that shows how much revenue a company earned over a specific time period.
- Balance Sheet: A financial statement that reports a company’s assets, liabilities and shareholders’ equity at a specific point in time.
Sources for More Information
- Investopedia: Investopedia provides investment and finance education, including an entry on Capitalization vs Expensing.
- Accounting Tools: Accounting Tools is a great source for all subjects related to accounting and finance, including Capitalization vs Expensing.
- Corporate Finance Institute: CFI offers online certification and training courses, as well as guides on various finance concepts including Capitalization vs Expensing.
- Financial Express: This site provides news on finance and business, and they have made many articles related to the topic of Capitalization vs Expensing.
