As a business owner, you need to make many decisions. One of these decisions touches on how your business deals with its costs. When your business spends money, you can either account for the costs as expenses or capitalize the costs.
Expending and capitalizing of costs refer to how you can treat costs on your business’s financial statements. If you choose to expense the cost incurred, you should add the expense to your business’s income statement and then subtract the same amount from the business revenue to determine profit.
If you choose to capitalize the cost, you will count it towards your business capital expenditure. This means that you will account for the cost in your business balance sheet as an asset. Note that you should calculate the amount of depreciation associated with the asset and record this amount in the income statement. When preparing a cash flow statement, the cost should be recorded as cash outflow for investing activities.
Effects of capitalizing costs
When business costs are capitalized, they affect the financial statements of the business in the accounting period when they were incurred. Here are some of the ways capitalization of costs affects the business’s financial statements:
- Results in an increase in the amount of assets in the balance sheet
- Increases the amount of cash flow from operating activities
- Capitalization of costs results in higher profitability and as compared to when you expense the cost. Note that this impact of an increase in the profitability continues until the capital expenditure is greater than the depreciation.
- Capitalization of costs results in higher ROA and ROE in the initial accounting periods. However, this reduces in the later years.
- In the later accounting periods, capitalization of costs has the following impact in the financial statements.
- The amount of capitalized cost should be distributed over the asset’s useful life as an amortization expense/ depreciation.
- The asset’s value and the net income are reduced due to the depreciation
- Since depreciation isn’t a cash expense, the cash flow statement won’t be affected.
Effects of expending costs
If you categorize any expenditure as an expense, it will have the following effects on your business financial statements in the accounting period the expense was incurred:
- No entry will be made in your business balance sheet
- The net income will decrease. Note that lower net income will result in low retained earnings.
- Will result in decrease in the cash inflow from operating activities as expenses are cash outflow from business operations
- Low ROA and ROE in the initial years but they will increase in the later years.
Expending business costs lowers its profitability in the short run but the trend improves in the later years. On the other hand, capitalizing an expense increases the profitability in the short run. Since both expending and capitalizing costs have both advantages and disadvantages, you should compare them and pick what suits you best by utilising accounting services in Singapore to obtain help.