Principles of Financial Accounting: Plant Assets and Intangibles - Capitalizing vs. Expensing Costs

What It Is

Capitalizing vs Expensing Costs is a fundamental concept in financial accounting that determines how a company records and reports its expenses. If a company buys $10,000 of inventory, it can either expense the cost immediately or capitalize it as an asset and depreciate it over time. The choice between capitalizing and expensing costs affects the company's financial statements, including its balance sheet, income statement, and cash flow statement.

Key Concepts & Formulas

• Matching Principle: Matches costs with revenues in the same period.
  • Example: A company buys a machine for $10,000. It will depreciate the machine over 5 years, matching the cost with the revenues generated by the machine.
• Capital Expenditure: An expenditure that increases the company's assets and is expected to provide future benefits.
  • Example: A company buys a new building for $50,000. This is a capital expenditure that will be capitalized as an asset and depreciated over time.
• Depreciation: The allocation of the cost of a tangible asset over its useful life.
  • Example: A company buys a machine for $10,000 and depreciates it over 5 years using the straight-line method. The annual depreciation expense is $2,000 ($10,000 ÷ 5 years).
• Amortization: The allocation of the cost of an intangible asset over its useful life.
  • Example: A company buys a patent for $5,000 and amortizes it over 10 years using the straight-line method. The annual amortization expense is $500 ($5,000 ÷ 10 years).
• Gross Profit: Sales revenue minus Cost of Goods Sold (COGS).
  • Example: A company sells $100,000 of goods and has COGS of $60,000. The gross profit is $40,000 ($100,000 - $60,000).
• Operating Expenses: Expenses that are directly related to the company's operations.
  • Example: A company has operating expenses of $20,000, including salaries, rent, and utilities.
• Capitalized Cost: A cost that is capitalized as an asset and depreciated over time.
  • Example: A company buys a new machine for $10,000 and capitalizes the cost as an asset. The machine will be depreciated over 5 years.
• Expensed Cost: A cost that is expensed immediately and not capitalized as an asset.
  • Example: A company buys office supplies for $1,000 and expenses the cost immediately.

Journal Entry Examples

1. Capitalizing a Machine: Dr. Machine $10,000 Cr. Cash $10,000 Explanation: The company buys a machine for $10,000 and capitalizes the cost as an asset.
2. Depreciating a Machine: Dr. Depreciation Expense $2,000 Cr. Accumulated Depreciation $2,000 Explanation: The company depreciates the machine over 5 years using the straight-line method. The annual depreciation expense is $2,000.
3. Amortizing a Patent: Dr. Amortization Expense $500 Cr. Accumulated Amortization $500 Explanation: The company amortizes the patent over 10 years using the straight-line method. The annual amortization expense is $500.

Common Mistakes

1. Mistake: Confusing debits and credits for expense accounts. Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity.
2. Mistake: Not considering the matching principle when capitalizing costs. Correction: The matching principle requires that costs be matched with revenues in the same period. Capitalized costs should be depreciated or amortized over time to match the cost with the revenue generated.
3. Mistake: Not distinguishing between operating and non-operating expenses. Correction: Operating expenses are directly related to the company's operations, while non-operating expenses are not. Operating expenses are typically expensed immediately, while non-operating expenses may be capitalized as an asset.

Exam Tips

1. Tip: Remember that a debit increases assets and expenses, while a credit increases liabilities and equity.
2. Tip: The matching principle requires that costs be matched with revenues in the same period. Capitalized costs should be depreciated or amortized over time to match the cost with the revenue generated.
3. Tip: Distinguish between operating and non-operating expenses. Operating expenses are directly related to the company's operations, while non-operating expenses are not.

Quick Practice

1. Problem: A company buys a new machine for $10,000 and depreciates it over 5 years using the straight-line method. What is the annual depreciation expense? Answer: $2,000 ($10,000 ÷ 5 years) Explanation: The company depreciates the machine over 5 years using the straight-line method.
2. Problem: A company buys a patent for $5,000 and amortizes it over 10 years using the straight-line method. What is the annual amortization expense? Answer: $500 ($5,000 ÷ 10 years) Explanation: The company amortizes the patent over 10 years using the straight-line method.
3. Problem: A company has operating expenses of $20,000, including salaries, rent, and utilities. What is the effect on the company's income statement? Answer: The company's net income will decrease by $20,000. Explanation: Operating expenses are directly related to the company's operations and are typically expensed immediately.

Last-Minute Cram Sheet

1. Capital Expenditure: An expenditure that increases the company's assets and is expected to provide future benefits.
2. Depreciation: The allocation of the cost of a tangible asset over its useful life.
3. Amortization: The allocation of the cost of an intangible asset over its useful life.
4. Gross Profit: Sales revenue minus Cost of Goods Sold (COGS).
5. Operating Expenses: Expenses that are directly related to the company's operations.
6. Capitalized Cost: A cost that is capitalized as an asset and depreciated over time.
7. Expensed Cost: A cost that is expensed immediately and not capitalized as an asset.
8. Matching Principle: Matches costs with revenues in the same period.
9. Debit: Increases assets and expenses, decreases liabilities and equity.
10. Dividends are NOT an expense – they go directly to retained earnings.