Capitalizing and expensing are two different ways of recording a business expense transaction. Clear rules exist in the accounting world to differentiate between the two expense types and record each one. In order to ensure proper recording and reporting of a company's financial transactions, businesses and accountants need to become familiar with with the reasoning behind relevant accounting rules and standards.
Capitalizing
Capital expenditures, also known as capex, are dollars spent to create future benefits. For example, when a business buys fixed assets such as manufacturing equipment, or improves the value of an asset with a useful life that is longer than the current tax year. Another example is leasehold improvements or other additions that increase the value of a building.
Expensing
An expense is money spent to pay for items such as office supplies, telephone service or maintenance and repairs. This is money spent to cover costs that are not related to the direct production of goods or services. They also include costs for keeping assets maintained in good operating condition; however, the value of the asset is not increased and its useful life is not extended.
Revenue expenditures usually cover cash or equivalents paid out for goods and services to be used within a short time period. The amount is expensed on the profit and loss statement immediately, and the current expense matches with the current revenue generated for the same time period.
When to Capitalize
A business may spend large amounts of money for an air conditioning system for its building. The company should capitalize the air conditioner on its balance sheet, since the air conditioner will have a useful life of more than one year. The air conditioner must be depreciated each year until it reaches the end of its useful life. The useful life of assets varies depending on the type of asset. In this case, the air conditioner will be depreciated over the same life as the business building, or 39 years.
Capitalization Gray Areas
Some situations create challenges for proper expense recording, as they are unclear, and companies must look to accounting regulations put forth by the IRS, the Financial Accounting Standards Board (FASB) and the generally accepted accounting principles (GAAP) to make correct choices. Advertising has presented a challenge since companies would typically record the expense in the period it was incurred, on the profit and loss statement. However, in a case involving RJR Nabisco in 1998, the IRS argued that expenses for establishing an ad campaign are different than the costs of executing the campaign, and that costs should be capitalized because the ad campaign creates long-term benefits for more than one year, for the goods or services being advertised. According to U.S. GAAP 340-20, advertising expenses should generally be expensed when the advertising first takes place, or as the costs are incurred.
When to Expense
Routine equipment repairs qualify as revenue expenditures since they do not improve or extend the life of the asset, they just return it to its previous operating condition. Expenses of repairs and maintenance get recorded in the current period as Repairs and Maintenance expense on the profit-and-loss statement.
Tags: useful life, goods services, conditioner will, loss statement, money spent, more than, more than year