A cost that is incurred in the purchase of a fixed asset
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Although they both represent an outflow of cash, their accounting treatment is significantly different – in order to reflect the substance of the costs. Accrual-based accounting differs from cash-based accounting, where both types of costs are treated the same, and changes on the financial statements only reflect the movement of cash.
1. Capitalized costs
Capitalized costs are usually long term (greater than one year), fixed assets that are expected to directly produce cash flows or other economic benefits in the future. The costs are represented on the balance sheet as an asset.
The important aspect of capitalized cost is that they are not deducted from revenues during the period that they are incurred, but instead, the cost is spread out over the life of the asset in the form of depreciation and amortization.
Accumulated depreciation and amortization represent a contra-asset account that is meant to reduce the balance of the capitalized asset. Depreciation and amortization also represent expense items on the income statement.
All expenses incurred to bring an asset to a condition where it can be used is capitalized as part of the asset. They include expenses such as installation costs, labor charges if it needs to be built, transportation costs, etc.
Capitalized costs are initially recorded on the balance sheet at their historical cost. Historical costs are a value of measure that represents an asset at its original cost on the balance sheet. It does not necessarily reflect the current fair value of the asset.
2. Incurred expense
Incurred expenses are costs that are reflected in the income statement immediately as they are incurred. Therefore, unlike capitalized costs, the expense is not represented over time. Some examples of incurred expenses are:
Construction costs for building an asset (materials, labor, transportation, sales tax, and interest)
Intangible assets can also represent capitalized costs as well. Some examples include:
It is important to note that costs can only be capitalized if they are expected to produce an economic benefit beyond the current year or the normal course of an operating cycle. Therefore, inventory cannot be capitalized since it produces economic benefits within the normal course of an operating cycle.
Importance of Capitalized Costs
The importance of capitalizing costs is that a company can get a clearer picture of the total amount of capital that has been deployed on assets. It helps the company’s management measure the amount of profits earned over time in a more meaningful way.
For example, if a company is using cash-based accounting and acquires a piece of equipment. In the first year, the company will incur a huge cash outflow. However, in the following years, it will receive benefits from that equipment, but there are no costs that are reflected in the financial statements. It can result in uninformative financial statements when compared over time.
Now, if that company uses accrual-based accounting, the first year will not be a huge cash outflow, but instead, the company will receive an asset that depreciates over the life of the equipment. It essentially spreads the expense out over the life of the equipment, matching the expenses with the revenues generated.
Thus, the importance of capitalized costs is to smooth expenses over multiple periods instead of booking one large outflow at once.
Drawbacks of Capitalized Costs
Company management may want to capitalize more costs since the classification of capitalized assets can manipulate the financial statements in a way that they want the figures to appear.
For example, top executives who want to make the balance sheet appear more attractive can try to capitalize more costs so that assets are overstated.
Also, if management wishes to make the profitability of a company appear better in the current year, they may opt to capitalize costs so that the expenses are reflected in future years. Additionally, if a manager wants to purposefully make their profitability appear better in later years, they may opt to expense costs right away.
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