Understanding Accounting: Capitalizing vs. Expensing
Business owners need to make many big accounting decisions and what the company does with costs is among the biggest of these decisions. When companies spend money, they are often able to either account to the costs as an expense or to capitalise the costs. The decision will have an impact on the company’s balance sheet.
This guide will look at what capitalizing vs. expensing is all about, and delve deeper into the situations when companies should capitalise and when to expense. This guide will also look at the effect it has on the financial statements and the limitations of either method. Finally, you’ll also learn about the inappropriate use of the system and how to ensure your business’ accounting tactics are within the legal framework.
In this article, we will first describe 1) the definition of capitalizing vs. expensing, and discuss then 2) when to use capitalizing, 3) when to use expensing, 4) avoiding inappropriate capitalizing and expensing, and 5) a conclusion.
THE DEFINITION OF CAPITALIZING VS EXPENSING
Capitalizing and expensing are crucial accounting terms to know. In brief, it refers to how a cost is treated on the entity’s financial statements. This means businesses have two options when adding a cost to their financial statement. They can either expense it or capitalise it.
If the entity chooses to expense the cost, it is added on the income statement and subtracted from the business’ revenue to determine the profit.
On the other hand, when a business capitalises a cost, it is going to count towards capital expenditures. This means it will be accounted for on the entity’s balance sheet as an asset. In this case, the income statement will only feature the appropriate depreciation of the asset.
There are currently only guidelines to help businesses decide which costs could be capitalised and which could be expensed. No mandatory rules exist, although there are some legal loopholes to be aware of. Therefore, each company has some leeway into deciding what it wants to capitalise and to expense.
As we’ll discuss later in the guide, this lack of a set of lists has both advantages and disadvantages to a business. Capitalizing vs. expensing provides companies with opportunities to influence the company’s profits, directly influencing over the income statement.
There have been some instances where companies have used capitalizing vs. expensing against the common accounting procedures. While this might influence the short-term profits of the company, it can also do damage to the company’s finances. Certain practices might also be outright illegal.
While there is no mandatory guide, many countries have produced certain accounting guidelines for companies to use. For example, in the US, the Generally Accepted Accounting Principles (GAAP) must be followed by publicly trading companies.
An example of capitalizing vs expensing
Before we look at the available options in more detail, here’s a quick example of capitalizing vs. expensing in action. The example will give you an idea how the decision can impact a company’s financial statements.
Company A has recognised $4,000 in revenue and $3,000 in expenses during a financial year. The company has also incurred $500 in repair and maintenance costs for its tools, but it hasn’t yet decided whether to capitalise or expense this amount.
In case the company decides to expense the $500, it will be added to the company’s total expenses. This will mean the company’s income will decrease for the year by $500. Expensing the cost will also mean total assets and the shareholder’s equity will be lower.
On the other hand, the company could also capitalise the $500. This means it won’t be recognised as an expense in that financial year, increasing the net income by $500. However, the $500 will be recognised in the statement in the following few years as depreciation expense. This means it will lower the future net income of the company.
As you can see, companies often have to weigh in on the pros and cons of capitalizing vs. expensing. The next section will look at these situations in more detail and give you an idea as to when cost should be capitalised and when expensed.
You can watch the below YouTube video for another example of capitalizing vs. expensing:
Dividing assets into two
When it comes to deciding whether a cost should be capitalised or expensed, companies often use a simple method of dividing assets into two categories. These are:
- Assets that produce future benefits
- Assets that do not produce any future benefits
Certain costs to the company will only provide a one time value for the company and therefore belong to the second group. These are typically expensed costs because the business won’t enjoy future benefits through them.
On the other hand, assets that provide future benefits can often be capitalised and thus the expenses spread across financial statements. Examples of these kinds of assets will be dealt with more detail in the next section.
A simple example could be an insurance policy payment. A company could buy a fixed period policy for two years and pay the cost upfront at once. Since the insurance will benefit the company in the future as well, it could capitalise the costs.
WHEN TO USE CAPITALIZING
As mentioned above, companies can typically capitalise costs only when the resource acquired will provide future benefits. This means resources that are beneficial for the business for more than one operating cycle.
Therefore, the expenses from acquiring these resources are recorded as assets in the company’s balance sheet. The costs will then show on the balance sheet in the coming financial years through amortisation or depreciation.
Examples of these resources could be anything from machinery to a business property.
Companies should also consider capitalizing costs when they add significantly to the value of an existing resource. If the company upgrades part of the tools, property or equipment it uses, in a manner that directly increases the value of the asset, it could be capitalised.
In many instance, fixed assets are typically capitalised, as they continue to provide benefits for the company for a longer period.
Companies can also deal with intangible assets. These are non-monetary resources, which have no physical substance yet still provide the company a benefit. These could be items such as research and development costs or patents and copyrights.
Intangible assets that can be capitalised often include:
- Full acquisition costs of obtaining a patent or copyright from another entity.
- Full acquisition costs of obtaining a brand or a trademark from another entity.
- Software development costs with economic feasibility beyond one operating cycle.
How will capitalisation affect assets?
The decision to capitalise the costs will naturally have an impact on the company’s financial statements. Here are some of the main areas involved with asset capitalisation and how they can change the company’s financial statements.
- Net income – Capitalizing costs will smoothen the variability of the company’s reported income, as the cost will be divided between statements. In pure profitability terms, the company will enjoy higher profitability at the start.
- Stockholders’ equity – The effect will be minimal on the long-term, but at the start, stockholder’s equity will be higher.
- Cash flow from operations –If the company capitalises its costs, the impact will be only on cash flow from investment.
- Reported assets – The total assets of the company will increase when costs are capitalised.
- Financial ratios – The profitability ratio will be higher at the onset of capitalizing costs. Furthermore, operation-efficiency ratio will decrease and the equity turnover will be higher at the start.
Limitations of capitalizing
While the rule of thumb for capitalizing is whether the asset has long-term benefit or value increase for the company, there are certain limitations to this rule. For example, in the field of research & development (R&D), the costs often cannot be capitalised, even though the assets technically will provide long-term value for the company.
The main reason most countries don’t allow the capitalizing of R&D costs is to do with the uncertainty of the benefits. Calculating whether the investment’s future benefits will be difficult and therefore, it is easier to expense the costs.
Nonetheless, you want to check with your local accountant, as different countries might have different ways to analyse R&D costs.
You also need to keep in mind that capitalizing an asset can overinflate the assets shown on the company’s balance sheet. This can have some influence on your financial statement.
Finally, it is crucial to remember inventory costs cannot be capitalised. Even if you are going to hold on to the inventory long-term and won’t be selling it during the next business cycle, you cannot capitalise the expenses.
WHEN TO USE EXPENSING
In its essence, expensing is performed whenever you purchase an asset. But the above section showed the limits to this rule. Typically only costs, which have no long-term benefit or which don’t directly increase the value of the asset substantially, are expensed.
The above also showed that deciding whether to capitalise or to expense isn’t always so straightforward. There are certain costs which might seem like a good idea to capitalise, but are actually better for the finances when they are expensed.
Many accounting practices recommend using the de minimus rule. This means that items, which could potentially be capitalised, are expensed only if they don’t significantly distort the bottom line in the balance sheet. This means the expenses in question don’t represent a large part of your total expenses and therefore, wouldn’t drag your income artificially low.
While there are no official rules to what this percentage is, many experts suggest using a figure below 0.1% of gross expenses for the financial year or 2% of the total depreciation and amortization expenses.
In addition, R&D expenses are nearly always expensed for accounting purposes. In terms of repair costs, maintenance-type repairs are considered an expense, since they only restore the item’s value to normal and don’t increase its lifespan above normal.
How will expensing affect assets?
As with capitalizing, the decision to expense assets will have an impact on the company’s financial accounts. The following are some of the key effects of expensing costs:
- Net income – Expensing costs will have an immediate impact on the company’s income, as increased expenses will naturally drag down the income of the business. Companies that actively use expensing in their accounting tend to have higher variability in reported income. Expensing costs can boost profitability in the long-term.
- Stockholders’ equity – The effect on stockholder’s equity will be relatively limited. Nevertheless, expensing companies tend to experience a lower equity at the start.
- Cash flow from operations – Expensing can drop the tax bill for the company in the short-term, although the impact will be evened out over the years. Nonetheless, a decision to expense the costs will be reported in cash flow from operations.
- Reported assets – The company’s total assets will be smaller.
- Financial ratios – The decision to expense will result in higher operation-efficiency ratios.
Limitations of expensing
There are certain special limitations to expensing, especially when it comes to starting up a business. In many instances, immediate costs can be capitalised even if they don’t necessarily fall under the capitalizing rules during the first financial year of the company.
You should also keep in mind that while R&D costs are typically considered an expense, certain legal fees involved in acquiring these, as well as patents, could be capitalised.
In addition, you need to be careful when expensing costs dealing with repairs or upgrades. If the value of the item significantly improves or the lifespan of the item expands, the costs might be better off capitalised.
Finally, expensing will bring down the income of the business and therefore, you want to be careful to ensure your short-term finances are able to adjust to this.
AVOIDING INAPPROPRIATE CAPITALIZING AND EXPENSING
Since the above are just guidelines, companies can find themselves in trouble with capitalizing vs. expensing decisions. Due to the nature of shifting the company’s balance sheet around, some companies fall guilty of using too aggressive accounting tactics.
The problem is mainly down to aggressive capitalizing. Since capitalizing can increase assets and boost income, companies often choose to capitalise instead of expensing. On the other hand, companies might occasionally try to bring down income by expensing, as this could lower the company’s tax burden.
How can you tell if your business is aggressively capitalizing expenses? The most obvious signs of aggressive accounting practices include:
- Sudden improvement in the company’s profit margin, especially a deep increase in specific assets.
- New asset line items on the company’s balance sheet, which do not seem to make sense and items which, are rapidly increasing.
- Sharply declining cash flow from operations.
- Unexpected rise in CAPEX, which does not represent current market conditions.
Furthermore, you should also be wary of overcapitalizing your costs. Even if you are able to capitalise parts of your research costs, full capitalisation will often cause red flags for the taxman.
In order to avoid inappropriate capitalizing and expensing, the following tips are essential to keep in mind:
- Learn about the guidelines – Check information on capitalizing vs. expensing from sources such as GAAP.
- Keep a close eye on changes in accounting policy.
- Make sure you understand the different capitalisation policies within your specific industry. You can often learn a lot by studying other company balance sheets.
- Decide your de minimus rule – You can set an appropriate level with your accountant and check whether a cost falls under the rule before you count it as an expense.
- Have a written capitalisation policy – Overall, accountants often recommend creating a written capitalisation policy for the business. This can be helpful in situations where you are uncertain over a specific cost, as well as help you defend your business strategy in case the tax authorities ask questions over your policy decisions.
When developing your accounting policy, consider things such as your business size, the level of revenue and expenses your business generates and its compliance needs in terms of taxes.
Tax authorities scrutinise company’s decisions to capitalise vs. expense carefully and you need to be able to properly justify your accounting decisions. While the above method can be used to tweak your company’s financial statement, you don’t want to be overly aggressive with your accounting tactics.
Capitalizing vs. expensing is an important aspect of business’ financial decision-making. Costs can have a big impact on your business finances and it is important to learn to take advantage of both capitalizing and expensing. The above should have given you a deeper insight into the appropriate use of these methods.
The accounting treatment of expenses can be the difference between a profitable income statement and one that highlights a loss. The decision to opt for either can be difficult. But in general, capitalizing vs. expensing can provide your business with opportunities to keep the financial future of the company on the right track.