Comparing Expense and Capitalization In Accounting

Accounting principles allow the purchase of large business items to be recorded on assets without cost other than depreciation expense on the income statement. In other words, the immediate cost of expensive business expenditures can be incurred over time via straight line or accelerated depreciation. This process is called capitalization of expenses and should not be confused with "capitalization" which is equity investment within a company.

Expensing is different from capitalizing of expenses because items i.e. assets or services are not depreciated in this method. Instead, with this accounting technique, when items are expensed immediately the costs are realized as a reduction to revenue rather than an increase to the liabilities of a company. If the expense is to be paid over a few months, all or part of it may become a short-term liability but will usually quickly become expensed as the debt is paid.

How to expense and capitalize costs 

To expense an item assets are debited if it is a product or prepaid service and liabilities are credited if the expense will payable in the future. If the expense is payable immediately, revenue is debited and cash is credited since revenue expenses are credit accounts and assets are debit accounts.

To capitalize and expense, assets are debited i.e. usually a long term or fixed asset and liabilities are credited. Then, as expenses are realized through depreciation, liabilities are debited and revenue is credited as an expense. Thus, instead of immediately lowering revenue and therefore profit calculations, capitalized expenses increase assets and liabilities for a balanced increase in both.

Advantages of expensing 

The advantages of expensing are not the same as those of capitalizing, however since capitalizing of expenses is only realized for larger expenditures the benefits of capitalizing expenses cannot be realized when expensing and vice versa. Below are a few of the advantages that may be realized with the expensing method:

• Increases to liabilities are short lived if accrual and do not occur if paid immediately
• Taxable income may decline more than a capitalized expense depending on the exact amounts
• Interest payments, if any, will likely be short lived
• May not involve as much bookkeeping requirements as large capitalized expense

Advantages of capitalization 

Capitalizing expenses is a little more complicated than expensing but can have advantages that aren't realized with expensing. These advantages may have a greater impact on a company because the monetary amounts of capitalized expenses are larger. A few of the potential benefits of capitalized expenses are listed as follows:

• Does not have as a dramatic effect on the income and income statement as when fully expensed.
• May encourage equity investments
• Interest and/or value changes of debt over time may end up costing less
• Has potential tax benefits that can add additional value and/or savings to the expenditure

Since many businesses don't operate with zero debt, looking into different ways of expensing purchases may be wise to an overall business strategy. Two such methods of expensing are short term expensing and capitalization expensing. The former is usually used with more current and/or revolving expenses such as pre-paid services whereas the latter usually applies to larger, more long-term expenditures such as buildings, and expensive equipment or machinery. Each method has unique advantages, bookkeeping requirements, and effects on financial statements and income numbers.

Sources:

1. http://www.answers.com/topic/capitalize?cat=biz-fin
2. http://www.admin.mtu.edu/admin/procman/ch2/ch2p9.htm
3. http://www.dwmbeancounter.com/tutorial/MouseQuizzes/Test4-1.html