Capitalized cost definition
/What is a Capitalized Cost?
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, typically more than one year. 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.
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. Consequently, the capitalization of costs will cause reported profit levels on the income statement to vary from the associated cash flows reported on the statement of cash flows.
Related AccountingTools Courses
Accounting for Intangible Assets
Disadvantages of Capitalized Costs
The main problem with the use of capitalized costs is that expenditures are not recognized on the income statement for a long time. This means that substantial cash outflows are required for these expenditures, which are not reflected in the income statement. Thus, an organization’s income statement could reveal robust profits, while it is actually teetering on the edge of bankruptcy because it has minimal cash on hand. This is a particular concern for undercapitalized businesses that do not have sufficient cash on hand to adequately fund their operations.
Examples of Capitalized Costs
Examples of capitalized costs include the following:
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