3.8 Capitalized Costs v. Expenses
When a business purchases a long-term asset (used for more than one year), it classifies the asset based on whether the asset is used in the business’s operations. If a long-term asset is used in the business operations, it will belong in property, plant, and equipment or intangible assets. In this situation the asset is typically capitalized. Capitalization is the process by which a long-term asset is recorded on the balance sheet and its allocated costs are expensed on the income statement over the asset’s economic life.
In short- CAPITALIZE means to record the item as an ASSET on the BALANCE SHEET.
EXPENSE items that do not have long-term, future value or are immaterial (small dollars).
Long-term assets that are not used in daily operations are typically classified as an investment. For example, if a business owns land on which it operates a store, warehouse, factory, or offices, the cost of that land would be included in property, plant, and equipment. However, if a business owns a vacant piece of land on which the business conducts no operations (and assuming no current or intermediate-term plans for development), the land would be considered an investment.
YOUR TURN! Select the best option for each scenario.
Property, Plant, and Equipment (Fixed Assets)
Why are the costs of putting a long-term asset into service capitalized and written off as expenses (depreciated) over the economic life of the asset? Let’s return to Liam’s start-up business as an example. Liam plans to buy a silk-screening machine to help create clothing that he will sell. The machine is a long-term asset, because it will be used in the business’s daily operation for many years. If the machine costs Liam $5,000 and it is expected to be used in his business for several years, generally accepted accounting principles (GAAP) require the allocation of the machine’s costs over its useful life, which is the period over which it will produce revenues. Overall, in determining a company’s financial performance, we would not expect that Liam should have an expense of $5,000 this year and $0 in expenses for this machine for future years in which it is being used. GAAP addressed this through the expense recognition (matching) principle, which states that expenses should be recorded in the same period with the revenues that the expense helped create. In Liam’s case, the $5,000 for this machine should be allocated over the years in which it helps to generate revenue for the business. Capitalizing the machine allows this to occur. As stated previously, to capitalize is to record a long-term asset on the balance sheet and expense its allocated costs on the income statement over the asset’s economic life. Therefore, when Liam purchases the machine, he will record it as an asset on the financial statements.
When capitalizing an asset, the total cost of acquiring the asset is included in the cost of the asset. This includes additional costs beyond the purchase price, such as shipping costs, taxes, assembly, and legal fees. For example, if a real estate broker is paid $8,000 as part of a transaction to purchase land for $100,000, the land would be recorded at a cost of $108,000.
Over time as the asset is used to generate revenue, Liam will need to depreciate the asset.
Depreciation is the process of allocating the cost of a tangible asset over its useful life, or the period of time that the business believes it will use the asset to help generate revenue.
A short-term or long-term asset that is not used in the day-to-day operations of the business is considered an investment and is not expensed, since the company does not expect to use up the asset over time. On the contrary, the company hopes that the assets (investment) would grow in value over time. Short-term investments are investments that are expected to be sold within a year and are recorded as current assets.
CONCEPTS IN PRACTICE
Vehicle Repairs and Enhancements
Automobiles are a useful way of looking at the difference between repair and maintenance expenses and capitalized modifications. Routine repairs such as brake pad replacements are recorded as repair and maintenance expense. They are an expected part of owning a vehicle. However, a car may be modified to change its appearance or performance. For example, if a supercharger is added to a car to increase its horsepower, the car’s performance is increased, and the cost should be included as a part of the vehicle asset. Likewise, if replacing the engine of an older car extends its useful life, that cost would also be capitalized.
Repair and Maintenance Costs of Property, Plant, and Equipment
Long-term assets may have additional costs associated with them over time. These additional costs may be capitalized or expensed based on the nature of the cost. For example, Walmart’s financial statements explain that major improvements are capitalized, while costs of normal repairs and maintenance are charged to expense as incurred.
An amount spent is considered a current expense, or an amount charged in the current period, if the amount incurred did not help to extend the life of or improve the asset. For example, if a service company cleans and maintains Liam’s silk-screening machine every six months, that service does not extend the useful life of the machine beyond the original estimate, increase the capacity of the machine, or improve the quality of the silk-screening performed by the machine. Therefore, this maintenance would be expensed within the current period. In contrast, if Liam had the company upgrade the circuit board of the silk-screening machine, thereby increasing the machine’s future capabilities, this would be capitalized and depreciated over its useful life.