Management typically has some discretion in determining if the cost of an item should be capitalized to the balance sheet and depreciated (or amortized if it is an intangible asset) to the income statement over time or if the cost of the item should be fully expensed to the income statement in the current period. In general, any expenditure that is expected to provide economic benefits for multiple accounting periods should be capitalized.
When a cost is capitalized, it is reported in the balance sheet as an asset. The cost is then allocated to the income statement over multiple periods as depreciation expense for tangible assets and amortization expense for intangible assets.
On the other hand, if a cost is expensed in the current period, it reduces the pre-tax income by that amount.
Once an asset has been capitalized, any more expenditure related to the asset that will increase its useful life will also be capitalized. However, any expenditure that helps the company maintain the asset will be expensed to the income statement.
Let’s take an example. Suppose a firm purchased new machinery for $100,000. This amount includes the freight and taxes. After that the company spent $5,000 to install the machinery and another $2,000 was spent on training the staff. Every year the company spent $3,000 for maintenance of the machinery. After 5 years, the company spent $25,000 on the machinery that helped the company in extending the life of the equipment. The following table summarizes which costs are capitalized and which ones are expensed.
|Purchase cost – $100,000||Yes|
|Installation – $5,000||Yes|
|Training – $2,000||Yes|
|Maintenance – $3,000||Yes|
|Rebuilding – $25,000||yes|
Impact on Financial Statements
The following table provides examples of the effects on a company’s financial statements and ratios when expensing in-year versus capitalizing in-year.
|Net Income, Profit Margins, Equity||Lower||Higher||Capitalizing delays expense recognition. Over the life of the asset, the total net income in both cases will be same.|
|Asset Turnover||Higher||Lower||Under capitalization, net income is higher, and therefore shareholder’s equity is higher.|
|Debt to Equity Ratio||Higher (Equity is Lower)||Lower (Equity is Higher)|
|ROA and ROE||Lower||Higher|
Cash Flows and Expensing vs. Capitalizing of Purchases
On a total cash flow basis, the decision to expense or capitalize has no impact because depreciation is a non-cash expense. However, when Cash Flows are separated by: Operating Activities, Investing Activities, and Financing Activities, the decision to expense or capitalize takes on more meaning.
Cash Generated by Operating Activities – when a company expenses an item paid with cash, instead of capitalizing it, the firm will show lower operating cash flows.
Cash Generated by Investing Activities – when a company expenses an item paid with cash, instead of capitalizing it, there will be NO CHANGE to investing cash flows. However, if the company capitalizes the item as a physical investment in PPE, investing cash flows will be lower.
Capitalization of Interest Expenses
US GAAP and IFRS-IAS provide treatment of the capitalization of interest expenses associated with the construction of long-lived assets. When a firm is constructing a long-lived asset, the interest accrued during the period of construction is capitalized as a part of the cost of the asset. The interest is capitalized in order to accurately measure the cost of the asset. Only interest up to the construction cost can be capitalized.
If the firm has borrowed funds for construction and has earned income by temporarily investing these funds, then the interest to be capitalized is reduced by the amount of income under IFRS. No such offsetting is allowed under US GAAP.
When interest is capitalized, it’s added to the asset cost in the balance sheet and does not show as interest expense on the income statement. If the asset is for the firm’s own use, then it is allocated to income statement as depreciation expense. If the asset is held for sale, then it is allocated to income statement as COGS.
In the cash flow statement, the capitalized interest is shown as outflow under investing activities.
Since capitalizing interest, reduces the interest expense, it increases the interest coverage ratio (EBIT/interest expense).