To capitalize or to expense

March 10, 2012

Learn about the impact of capitalizing vs expensing costs in the current and future periods.

1. Asset capitalization and matching principle

It is important to understand why management selects various accounting methods acceptable under U.S. GAAP (Generally Acceptable Accounting Principles). In other words, it is useful to understand how management incentives can impact financial transactions and how these transactions could affect financial statements.

One of the essential principles to know is the asset capitalization concept and how it is related to the matching principle. The matching principle mandates that the expenses of a business need to line up with its revenue. The expense of doing business is recorded in the same period as the revenue that has been generated as the result of incurring that expense. To better understand the matching principle, let’s look at the steps involved in analyzing expenses incurred:

  1. Which costs were incurred in this period to generate revenues?
  2. When these revenues can be recognized? (i.e., see revenue recognition principle)
  3. If the revenue can be recognized in the current period, cost is expensed.
    If the revenue can be recognized in the future period, cost is capitalized.
  4. If costs are capitalized in the current period, these costs should be expensed in the future periods when related revenues are recognized.

To see some examples of the application of these steps, refer to the table below:

Step 1: Cost

Step 2: Revenue

Step 3: Current period

Step 4: Future period

Salaries

Current period

Dr Salaries Expense

Cr Salaries Payable

None

Inventory purchase

Future period *

Dr Inventory

Cr Accounts Payable

Dr Cost of Goods Sold

Cr Inventory

Machinery purchase

Future period *

Dr Machinery

Cr Accounts Payable

Dr Depreciation Expense

Cr Accumulated Depreciation

Prepaid rent

Future period *

Dr Prepaid Rent

Cr Cash

Dr Rent Expense

Cr Prepaid Rent

(*) For simplicity let’s assume that such costs relate to future period revenues only. However, in reality a portion of such costs can be and, in most cases, are expensed in the current period as well.

Cost capitalization and cost expensing have different effects on the balance sheet and income statement. By capitalizing a cost, a company can increase its assets and net income in the current period at the “expense” of the future periods: capitalized cost (i.e., asset) will be amortized and as the result will reduce net income in the future periods. Hence, the accounting choice concerning asset capitalization might create incentives for companies to manage earnings.

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