Capitalization Cost Definition
Capitalization Cost is an expense that is made by the company to acquire an asset which they will use for their business and such costs are shown in the balance sheet of the company at the year-end. These costs are not deducted from the income but they are depreciated or amortized over the period of time.
- Capitalization is done for assets that are to be shown in the fixed asset in the balance sheetFixed Asset In The Balance SheetFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.. Then they are depreciated over a period. It is an expense that is made to acquire the asset to put it to use in the business. There are several expenses which a company incurs.
- Suppose a company makes a payment of $ 10000 on paying salaries to their employees or for paying rent of the business premises, then it is not a capitalization cost. It is a normal expense which a company will incur.
- However, suppose the company makes a $10000 payment to buy a machine that it will use in the business. It is a capitalization of the cost of the company. It will get depreciated over the useful life of the asset. Therefore, whenever the company invests money to acquire an asset that will be useful for the company, which is considered as a capitalization cost.
Examples of Capitalization Cost
- Material is to be used for the construction of the asset, which is capitalized over the years.
- Labour Expenses for the work of completion of the construction of the fixed asset.
- Interest Expenses are also an example of capitalization if the interest is associated with the loan element, which is used to purchase the asset.
- Trademarks, Patents are also capitalized because the amortizationAmortizationAmortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset. will be calculated and deducted from them every year.
- An Asset that is being purchased by the company and will put that to use.
- Installation Cost associated with the asset, if any;
- Research and Development Cost in the later stages of the software development company.
How to Calculate Capitalization Cost?
- The asset is purchased for the company and will be put to use in the business.
- Determine the approx useful lifeDetermine The Approx Useful LifeUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets. of the asset or the duration of the asset in which it can be used.
- Consider the salvage valueSalvage ValueSalvage value or scrap value is the estimated value of an asset after its useful life is over. For example, if a company's machinery has a 5-year life and is only valued $5000 at the end of that time, the salvage value is $5000. of the asset as per the market condition and the condition of the asset.
- Add up all the expenses associated with the asset to make it useful for the organization, for example, maintenance, repair, oiling expense, etc.
- Calculate the entire interest element associated with the loan if taken to acquire the asset.
- Now we can calculate it by subtracting the profits with the cost associated with the asset.
- We calculate it as a percentage of the total cost, and from there, we can determine the present value of the asset.
We treat it as an asset for the company, which will be depreciated over some time. In the books of accounts, we have to debitDebitDebit is an entry in the books of accounts, which either increases the assets or decreases the liabilities. According to the double-entry system, the total debits should always be equal to the total credits. the asset with the purchase amount and credit the account, which paid for the asset, i.e., Cash or Bank a/c.
- It helps to enhance the income of the company because the costs which are capitalized for the assets will be depreciated over a period of time. Thus this will help the company to avoid taxesAvoid TaxesTax avoidance is the process of reducing the income tax liability of an individual or firm by adopting the lawful methods. The taxpayers can claim exemptions and deductions as allowed under the nation's tax provisions. Such as investments in municipal bonds and deductions for business loss. and thus helps in the profit maximization of the company.
- The companies are not required to book the expenses made for the asset, which is being capitalized. Rather, the cost is being equally distributed throughout the useful life of the asset.
- Capitalization enhances the value of the asset as well because it includes the asset value and also the amount which is levied to bring the asset to its use, i.e., installation cost, shipping cost, etc.
- The capitalization will also have a positive impact on the cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. of the organization because the capitalized costs will show a higher income earned in the year, there is an increase in the value of the asset, and the equity is lowered. Thus the cash flow will show a positive impact.
- It is not that beneficial when it comes to capitalizing on the interestCapitalizing On The InterestCapitalized interest is the cost of borrowing incurred to acquire or construct the long term asset to be used in the business and is added in the asset's value to be shown in the balance sheet, instead of showing it as an interest expense in the company's income statement. cost of the loan to get the asset. The company cannot reduce the tax obligation since the interest payments get deferred over the period. The taxes levied may harm the income of the organization. The company will not be able to enjoy the tax benefitTax BenefitTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place. out of that transaction.
- The company sometimes makes too much capitalization of its assets. It has been witnessed in the software companies that the management decides to capitalize on the entire software cost related to the research and development of the software. Whereas the early-stage research and development should be expensed off and the rest can be capitalized, but they show the entire research and development cost in their balance sheetTheir Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. and not in their statement of profit and loss account.
- The companies invite the manipulations when it comes to a decision making whether the cost is to be expensed off or should be capitalized, and thus, they end up making wrong accounting treatments.
It helps the organization when it comes to investment, which the company makes in big assets, and that asset, if, qualifies the criteria should be capitalized. Still, on the contrary, the company should take extra care while finalizing its accounts because all big expenses related to the assets cannot be considered as Capitalization Cost, and that has to be expensed off during the period it is incurred.
This article has been a guide to What is Capitalization cost and its Definition. Here we discuss how to calculate capitalization cost along with journal entry and example. You can learn more about from the following articles –