A capitalized cost is recognized as part of a fixed asset, rather than being charged to expense in the period incurred. Capitalization is used when an item is expected to be consumed over a long period of time. If a cost is capitalized, it is charged to expense over time through the use of amortization (for intangible assets) or depreciation (for tangible assets).
A short-term variation on the capitalization concept is to record an expenditure in the prepaid expenses account, which converts the expenditure into an asset. The asset is later charged to expense when it is used, usually within a few months.
Capitalized costs typically arise in relation to the construction of buildings, where most construction costs and related interest costs can be capitalized.
Examples of capitalized costs include:
- Materials used to construct an asset
- Sales taxes related to assets purchased for use in a fixed asset
- Purchased assets
- Interest incurred on the financing needed to construct an asset
- Wage and benefit costs incurred to construct an asset
- Demolition of a site to prepare it for new construction
- Transport costs incurred to bring a purchased asset to its intended location
- Testing costs incurred to ensure that an asset is ready for its intended use
Capitalization meets with the requirements of the matching principle, where you recognize expenses at the same time you recognize the revenues that those expenses helped to generate. Thus, if you construct a factory that will last for 20 years, it should be housing production equipment during those 20 years that will generate revenues, so you should depreciate the cost of the factory over the same 20 year period.
Since capitalized costs are usually depreciated or amortized over multiple years, capitalizing a cost means that it will have an impact on profits for multiple reporting periods into the future. However, the related cash flow impact is immediate, if a cost is paid for up front. Subsequent depreciation or amortization is a non-cash expense.