When To Capitalize vs Expense Payments Made
Tim is a Certified QuickBooks Time (formerly TSheets) Pro, QuickBooks ProAdvisor, and CPA with 25 years of experience. He brings his expertise to Fit Small Business’s accounting content.
Eric is a staff writer at Fit Small Business and CPA focusing on accounting content. He spends most of his time researching and studying to give the best answer to everyone.
This article is part of a larger series on Bookkeeping.
Capitalized payments create an asset on your balance sheet, while expensed payments reduce the net income on your income statement. In general, payments to purchase or repair fixed assets should be capitalized if the amount is material and the asset will generate a benefit to the company over multiple years. In practice, capitalizing vs expensing payments related to fixed assets is a gray area, but a crucial concept to understand for good fixed asset accounting. Manage business expenses with the right software. Check our guide on the best business expense tracker.
Capitalize | Expense |
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Effect of Capitalizing vs Expense Payments in the Income Statement
The issue of whether to capitalize an expense has an effect on the financial statements. Moreover, the gray areas of capitalization can also be a breeding ground for tax fraud or financial statement manipulation. Let’s go over the effects on financial statements of capitalizing vs expensing a payment.
Ollivander Woodworks purchased a wood cutting machine intended for the production of wood furniture. The cost of this machine is $50,000 with a useful life of five years and no residual value. In the first year, the company paid a subsequent cost of $10,000. Obviously, the $50,000 purchase price must be capitalized. Let’s look at the effect on the financial statements if we capitalize vs expense the $10,000 in subsequent costs.
Let’s assume the following income statement figures over the next five years if the $10,000 subsequent cost is capitalized along with the $50,000 purchase price.
Assuming the $10,000 payment was CAPITALIZED | |||||
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Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Net Income Before Depreciation | $16,000 | $17,000 | $18,000 | $19,000 | $20,000 |
Depreciation Expense of Purchase Price ($50,000 ÷ 5 years) | ($10,000) | ($10,000) | ($10,000) | ($10,000) | ($10,000) |
Depreciation of Subsequent Cost ($10,000 ÷ 5 years) | ($2,000) | ($2,000) | ($2,000) | ($2,000) | ($2,000) |
Net Income | $4,000 | $5,000 | $6,000 | $7,000 | $8,000 |
When we capitalized the expense, we didn’t record an expense in year 1. However, the effect of capitalization would be a higher depreciation expense. In effect, we distributed the $10,000 payment through depreciation. Instead of charging all of the $10,000 as expense in year 1, we spread it out at $2,000 per year as depreciation expense. Now, let’s look at the effect of charging it to expense in year 1.
Assuming the $10,000 payment was CHARGED TO EXPENSE IN YEAR 1 | |||||
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Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Net Income Before Depreciation & Subsequent Cost | $16,000 | $17,000 | $18,000 | $19,000 | $20,000 |
Depreciation Expense of Purchase Price ($50,000 ÷ 5 years) | ($10,000) | ($10,000) | ($10,000) | ($10,000) | ($10,000) |
Subsequent Cost (expensed) | ($10,000) | - | - | - | - |
Net Income (Loss) | ($4,000) | $7,000 | $8,000 | $9,000 | $10,000 |
In year 1, we charged the entire $10,000 to expense which resulted in a net loss of $4,000. Although it may look bad that we had a net loss, let’s compare the net income under the two assumptions:
Net Income Comparison ― Capitalize vs Expense | ||||||
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Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Total | |
Net Income If Capitalized | $4,000 | $5,000 | $6,000 | $7,000 | $8,000 | $30,000 |
Net Income If Expense | ($4,000) | $7,000 | $8,000 | $9,000 | $10,000 | $30,000 |
Net Effect | $8,000 | ($2,000) | ($2,000) | ($2,000) | ($2,000) | - |
Notice that in year 1, our net income is higher by $8,000 if we capitalized vs expensed the subsequent asset cost. In succeeding years, observe that the difference reverses by $2,000 per year, which is the annual depreciation if the cost is capitalized.
Regardless of the option we choose, our total income remains the same over the life of the asset whether we capitalize vs expense a payment. The difference in income is merely a temporary timing difference because we spread out the expense across several periods when we capitalized it to the asset.
Most companies prefer capitalizing expenses for book purposes to avoid the large reduction in net income in year 1. However, for income tax purposes, these same companies prefer expensing so they get the tax savings of the deduction in year 1. Be careful treating asset-related payments differently between book and tax accounting because the rules are very similar and you may have difficulty justifying the current deduction on your income tax return if you capitalized the payment on your books.
Journal Entries To Capitalize vs Expense Asset Payments
When we capitalize payments, we debit the payment to our fixed asset account. The payment will increase the balance of our asset account in the balance sheet. If we charge it to expense, we debit the payment to Repairs Expense. The effect of capitalizing would be a gradual transfer of the repairs and maintenance cost to profit and loss over years through depreciation.
CAPITALIZE | EXPENSE | ||
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Equipment Cash | $10,000 $10,000 | Repairs Expense Cash | $10,000 $10,000 |
Bottom Line
Knowing when to capitalize vs expense a subsequent cost related to a fixed asset requires careful consideration. From an accounting perspective, the two options have no effect on overall net income over the life of the asset. However, there’s a difference in net income across years due to timing differences. While it’s important to understand the consequences of each treatment, the decision should be based on whether the payment improves the asset vs merely restoring it to its original operating condition.
