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 sheet and then they are depreciated over the period of time. 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 will be used in the business that will be considered as a capitalization cost of the company. This will get depreciated over the useful life of the asset. Therefore, whenever the company invests any money to acquire an asset which will be useful for the company that 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 of time.
- Labor 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 amortization 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 life of the asset or the duration of the asset in which it can be used.
- Consider the salvage value 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.
- It is calculated as a percentage of the total cost and from there the present value of the asset can be determined.
It is treated as an asset for the company which will be depreciated over the period of time. In the books of accounts, we have to debit the asset with the amount in which it has been purchased and credit the account which has been used to pay 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 the period of time and thus this will help the company to avoid taxes 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 flow of the organization because the costs which are capitalized will show a higher income earned in the year, the value of the asset is also increased 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 interest cost of the loan to get the asset. The company cannot reduce the tax obligation since the interest payments get deferred over the period of time. The taxes levied may have a negative impact on the income of the organization. The company will not be able to enjoy the tax benefit out of that transaction.
- The company sometimes makes too much capitalization of its assets. This 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 sheet and not in their statement of profit and loss account.
- The companies invite the manipulations when it comes to the 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 assets if qualifies the criteria should be capitalized but on the contrary, the company should take extra care while finalizing their 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 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 –