"Capitalizing" a cost allows a business to report that cost as an asset rather than an expense. Not only does this boost the company's value by putting more assets on its balance sheet, it also boosts the company's profit by reducing expenses. Corporate financial accounting follows U.S. generally accepted accounting principles, or GAAP. These principles include guidelines on what a company can capitalize and how it does so.
Capitalization vs. Expense
When companies incur costs, they can either "capitalize" those costs or "expense" them. Capitalizing a cost means converting it to an asset on the balance sheet. For example, if a company pays $10,000 in cash for piece of equipment, its financial statements don't show that it "spent" $10,000. Rather, they show that it converted $10,000 worth of cash into $10,000 worth of equipment, an asset. Expensing a cost, on the other hand, means reporting it on the income statement as an outflow of money. If a company pays $10,000 for rent, for example, its financial statements show that money as being "spent." Expenses directly reduce a company's net income, or profit, so the more costs a company can capitalize rather than expense, the greater the profit it can report to shareholders.
Definition of an Asset
GAAP defines a company's assets as the things it owns or controls that have measurable future economic value. If something doesn't fit that description, it can't be capitalized. Land, buildings, equipment, items held in inventory, stocks and bonds, even IOUs from customers (accounts receivable) have measurable future economic value, so a company can capitalize them as assets. Other costs, such as advertising, marketing and research and development, must be expensed. While these costs are certainly intended to produce future value, that value can't be reliably measured at present.
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What to Capitalize
GAAP allows companies to capitalize the full costs of acquiring an asset and preparing it for use. Suppose a publishing company buys a $5 million press from a manufacturer in Germany. Not only can the company capitalize the purchase price of the press, it can also capitalize the cost of transporting the equipment from Germany. Assembly costs, the cost of any necessary modifications to the company's printing plant, even taxes and tariffs paid on the presses, can all be rolled into the capitalized cost. On a far smaller scale, if a company buys $100 in stock for investment purposes and has to pay a $1 commission, it can capitalize the full acquisition cost: $101.
When a company capitalizes an asset, that doesn't necessarily mean it will never have to expense the cost. "Hard assets," such as property, plants and equipment, tend to lose value as time passes. Buildings deteriorate, vehicles and equipment break down, technology becomes obsolete. GAAP recognizes this and it requires companies to expense a portion of the asset's value for each year of its useful life. This is called depreciation. A $5 million printing press, for example, might have a useful life of 25 years, at the end of which it would be worth, say, $200,000 for scrap metal. So the company has to depreciate $4.8 million worth of value over 25 years. Under the most common depreciation method, the company would claim a depreciation expense of $192,000 a year. Depreciation also serves a second purpose under GAAP: the "matching principle." This principle says that when companies report revenue, they must simultaneously report, as expenses, all costs incurred in producing that revenue. For the printing press, the $192,000 in depreciation is an expense incurred to produce the revenue generated by the press that year.
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton et al; 2010
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