Capitalized costs are expenses that are recognized as part of a fixed asset, rather than being charged to the expense in the period in which it is incurred. This type of cost is used when an item is expected to be consumed for an extended period of time. If a cost is capitalized, the expense is spread out over time by using amortization (for intangible assets) or depreciation (for tangible assets). A short-term variation of capitalization involves recording an expense in the prepaid expense account, which converts the expense into an asset.
The asset is then charged to the expense when used, usually within a few months. Capitalized costs typically arise in connection with building construction, where most construction costs and related interest costs can be capitalized. Cost capitalization is used when a company disburses funds to acquire an asset that is expected to be used for a long time. In other words, it is counted as a cost incurred by the purchase of a fixed asset that is expected to directly produce an economic benefit beyond a company's normal operating cycle. If a cost is capitalized, it is spread out over time by amortizing intangible assets and depreciating tangible assets. Cost capitalization often arises with the construction of buildings where construction costs and related interest costs can be capitalized.
All expenses incurred to bring an asset to a condition where it can be used are capitalized as part of the asset. Such expenses may include, but are not limited to, installation costs, labor charges, and transportation costs. The Internal Revenue Service requires companies to take full advantage of business assets, such as land, machinery, patents and franchise rights. For example, if a company buys a machine, a building, or a computer, the cost will not be counted as an expense, but will be capitalized as a fixed asset on the balance sheet. It is possible to capitalize these expenses and include them as part of the fixed asset cost base. Unlike an ordinary (or operating) expense, which covers the daily costs needed to keep a business running, a capitalized expense is an expense that is made to acquire an asset (whether tangible or intangible) that has a useful life of more than one year or to improve the useful life of an existing capital asset (such as properties, plants, buildings, technology and equipment).
Instead of being counted as an expense, the cost of the item or fixed asset is capitalized and amortized or depreciated over its useful life. If a company employs cash accounting and purchases equipment, it will recognize a high cost in the year of the acquisition and, therefore, reduce profits that year. Since capitalized costs are depreciated or amortized over a certain number of years, their effect on the company's income statement is not immediate but rather extends over the useful life of the asset.
