Capitalized and Expensed Costs

Long-lived assets are assets that are expected to provide economic benefits over a future period of time; usually longer than one year. They include property, plant, and equipment (long-lived tangible assets); patents and trademarks (long-lived intangible assets); and investments in equity and debt securities issued by other companies (long-lived financial assets).

The costs of long-lived assets are usually capitalized, i.e., included in the asset shown on the balance sheet, and then allocated as expenses in the income statement over the period during which they are expected to provide economic benefits.

Capitalized Costs vs. Costs That are Expensed

Acquisition of Long-lived Tangible Assets

Whenever property, plant, or equipment is purchased, the asset is recorded on the balance sheet at cost. All expenditures necessary to get the asset ready for its intended use, are included as part of this cost.

Subsequent expenditures are capitalized, i.e., included as part of the recorded value of the asset on the balance sheet if they are expected to provide economic benefits beyond one year into the future. They are otherwise expensed if they are not expected to provide economic benefits in the future. It is worth noting that expenditures that extend the original life of a long-lived asset are typically capitalized.

Construction of Long-lived Assets

In instances when a company constructs an asset or acquires an asset whose preparation for use takes a long period of time, the borrowing costs incurred directly related to the construction (including those incurred prior to the readiness of the asset for use) are capitalized as part of the cost of the asset.

If a loan is taken for the purpose of constructing a building, the interest cost on the loan during the time of construction would also be capitalized as part of the building’s cost.  Under IFRS (but not US GAAP), the income that is earned on temporarily investing the borrowed monies will decrease the amount of borrowing costs that is eligible for capitalization.

If interest expenditure is incurred in relation to the construction of an asset for the company’s own use, the capitalized interest will appear on the company’s balance sheet as part of the relevant long-lived asset. The capitalized interest will be expensed over time as the value of the property depreciates and therefore becomes part of subsequent years’ depreciation expense rather than the interest expense for the current period.

If interest expenditure is incurred in relation to the construction of an asset to sell, the capitalized interest will appear on the company’s balance sheet as part of the inventory.  The capitalized interest will be expensed as part of the cost of goods sold when the asset is sold.

The interest payments that are capitalized and made prior to completion of construction are classified as a cash outflow from investments.  Under IFRS, the expensed interest may be classified as a cash outflow from either operating or financing activities, while under US GAAP, it is classified as a cash outflow from operating activities.

Question 1

A company purchased and installed new equipment while incurring the following costs:

$$ \begin{array}{|c|c|} \hline \textbf{Costs} & \textbf{Amount} \\ \hline \text{Acquisition cost} & {$7,000} \\ \hline \text{Insurance} & {$700} \\\hline \text{Installation } & {$350} \\\hline \text{Testing} & {$100} \\\hline \text{Staff training} & {$1,000} \\ \hline \end{array} $$

The total cost of the equipment that will be shown on the company’s balance sheet is closest to:

1. $7,450.
2. $8,150.
3. $9,150.

Solution

The correct answer is B.

Total capitalized costs = $7,000 + $700 + $350 + $100= $8,150. The $1,000 cost for staff training is not included as a part of the capitalized costs because it is not necessary for getting the equipment ready for its intended use; it will be expensed instead.

Question 2

Accent Hotel reported a refurbishment cost of $100,000 during the year. If you knew that the hotel makes refurbishments for 20% of its rooms every year, how should the $100,000 be treated on the financial reports of the hotel?

1. It should be fully expensed.
2. It should be fully capitalized.
3. Only 20% of the amount should be capitalized.

Solution

The correct answer is B.

The amount should be fully capitalized because the rooms are supposed to benefit the hotel for more than one single period; specifically five years.