Capitalization Cost Definition Example How To Calculate

Capitalization Cost Definition

Explanation

Capitalization is done for assets 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.read more. Then they are depreciated over a period. It is an expense to acquire the asset to put it to use in the business. There are several expenses that a company incurs.Suppose a company makes a payment of $ 10000 on paying salaries to their employees or paying rent of the business premises, then it is not a capitalization cost. It is a normal expense that 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 a capitalization cost.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Capitalization Cost (wallstreetmojo.com)

Examples of Capitalization Cost

Material is to be used to construct the asset, which is capitalized over the years.Labour Expenses for the work of completion of the fixed asset construction.Interest Expenses are also an example of capitalization if the interest is associated with the loan element 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.read more will be calculated and deducted from them every year.An Asset that the company is purchasing will be put 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 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.read more 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.read more of the asset as per the market condition and the asset’s condition.Add up all the expenses associated with the asset to make it useful for the organization, for example, maintenance, repair, oiling expenses, 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 from the cost associated with the asset.We calculate it as a percentage of the total cost, and from there, we can determine the asset’s present value.

Journal Entry

We treat it as an asset for the company, which will be depreciated. In the books of accounts, we have to debitDebitDebit represents either an increase in a company’s expenses or a decline in its revenue. read more the asset with the purchase amount and credit the account which paid for the asset, i.e., Cash or Bank a/c.

Advantages

It helps to enhance the company’s income because the costs capitalized for the assets will be depreciated over time. Thus this will help the company 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.read more 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 capitalized. Rather, the cost is equally distributed throughout the asset’s useful life.Capitalization enhances the asset’s value as well because it includes the asset value and 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. read more 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.

Disadvantages

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.read moreto 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.read more 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, 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.read more and not in their profit and loss account statement.The companies invite the manipulations when it comes to deciding whether the cost is to be expensed off or should be capitalized. Thus, they end up making wrong accounting treatments.

Conclusion

It helps the organization when it comes to investment, which the company makes in big assets, and that asset 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 Capitalization Costs. That has to be expensed off during the period it is incurred.