The difference between expensing and capitalizing
/What is Expensing?
A cost is the expenditure required to create and sell products and services, or to acquire assets. When a cost is associated with an expenditure that is consumed at once, then it is charged to expense. When this happens, the expense is reported on the firm’s income statement. This process is referred to as expensing. This approach to expenditures applies to the bulk of all payments relating to the operations of a business.
What is Capitalizing?
If an expenditure is expected to be consumed over a longer period of time, then it can be capitalized, in which case it appears as an asset on the company’s balance sheet. Capitalization means that the recognition of a cost as an expense is deferred until a later period. This process is referred to as capitalizing.
A capitalization limit is usually imposed on lower-cost expenditures that might not yet have been consumed, so that the accounting department is not burdened with the tracking of an excessive number of assets. This limit is usually set at a few thousand dollars, below which all costs are charged to expense.
Comparing Expensing and Capitalizing
There are several differences between expensing and capitalizing, which are as follows:
Consumption timing. Expensing is only applied when an expenditure is consumed at once, while capitalizing is applied when consumption occurs over a longer period of time.
Capitalization limit. A lower cap is usually imposed on the amount that can be capitalized, which is not the case when expenditures are charged to expense.
Financial statement impact. The immediate impact of expensing is on the income statement, while the immediate impact of capitalizing is on the balance sheet. That being said, a capitalized asset will start to be depreciated as soon as it is acquired and placed in service, which will have some immediate impact on the income statement.
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Examples of Costs Being Expensed
A business pays compensation to its employees in exchange for the work they perform for it. This compensation cost is consumed within the reporting period, and so is expensed. It cannot be capitalized, because there is no discernible future economic value associated with the payments.
As another example, the accounting department pays $200 for check stock, which it will use over the next few months to issue payments to its suppliers. Even though there is some future economic value associated with these checks, their cost is so low that they fall below the company’s capitalization limit, and so are charged to expense in the current period.
Examples of Costs being Capitalized
A business buys a delivery van for $50,000, and for which it expects to have a five-year useful life. Based on this information, the expenditure is recorded as a fixed asset, and is depreciated over five years.
As another example, a new wing is built onto a company’s corporate headquarters, at a cost of $2 million. This amount is fully capitalized as a separate fixed asset over the expected 30-year life of the constructed asset, with depreciation occurring over the full 30-year period.
In both of the cost capitalization examples, the amount capitalized is gradually being charged to expense, but over a much longer period of time than if they had been expensed at once.