Learn how some expenditures are expensed immediately and some are capitalized, or put on the balance sheet and expensed over time. It depends on management’s assessment of the likelihood of future benefit.
- You may have heard the phrase we'll capitalize those costs. What the devil does that mean? - The term capitalize has a very specific meaning when it comes to accounting and to the financial statements. Capitalize means that we believe an expenditures going to benefit more than one period. More than one year for example. - If that's the case then the cost of that expenditure should be spread out over the time periods that are expected to be benefited. So capitalize means to record the expenditure as an asset on the balance sheet and then expense that asset to the income statement over time.
- As opposed to just running the expenditure to the income statement immediately as an expense. So the choice is do we capitalize or do we expense? Do we put the expenditure on the balance sheet and as an asset and move it to the income statement in pieces over time? Or do we just run it to the income statement immediately? - [Instructor] Well that sounds kind of easy. If a cost benefits just this period, then it goes to the income statement this period. If a cost benefits multiple periods, then it is capitalized to the balance sheet and moved to the income statement over time. - [Instructor] Wow, that's so easy, look at some examples.
Consider buying a building. That obviously benefits several years, so that cost would be capitalized then the cost would be moved to the income statement over the estimated life of the building. - Yep, easy. - What about the wages paid to an employee? Capitalize or expense? - Well, that seems easy. They worked this period, we pay them this period. Expense, easy. - Okay, well what about advertising? For example, every year in the weeks of hype proceeding the Super Bowl, we hear about the incredible number of media people covering the event and about how much money advertisers are paying for a 30 second spot during the broadcast.
We also hear a little bit about the football teams. With advertising cost averaging millions of dollars for 30 seconds, one has to believe that the advertisers expect some future economic benefit from the advertising. So, should the advertising cost be capitalized or expensed? - Well, advertisers wouldn't be spending that kind of money unless they expected that expenditure to have some sort of benefit. - Right, but will that benefit extend into more than one accounting period? If it will, then one could argue that the cost should be capitalized and expensed over time.
- Well, those benefits might extend into more than one accounting period. - [Instructor] And now we get into some specific accounting terminology to be capitalized an expenditure must meet the technical definition of an asset which means the expenditure will provide probable future benefit, probable is a high bar. - So the fact that these benefits might extend into future periods does not mean the expenditures for advertising should be capitalized. Might is not probable. Might sounds more like possible and possible means these costs should probably be expensed.
- Exactly, now of course there are always exceptions. In selected cases in which the future benefits are more certain, advertising costs should be capitalized. This type of advertising involves targeted advertising to customers who have purchased products in the past. Such advertising is also characterized by the ability to estimate how many customers will respond favorably. In these cases, it is determined that the future benefit is probable and therefore those costs should be capitalized. - Well, are there any other hard ones? - [Instructor] Yes, consider research and development.
Should expenditures relayed at the R&D be capitalized or expensed? - Well, companies invest in R&D with the hope that those expenditures will benefit the future. But now that I think about it, hope doesn't seem like it makes the probable standard that is required in order to be capitalized so I'm going to say that those costs are expensed. - And the correct answer depends on where in the world you are. In the United States, the reasoning has been consistent with yours. With the frequent inability to find a definite cause all relationship between the expenditures and future revenues, the rule makers of the United States have elected to be conservative and expense all R&D costs.
But the rest of the world has, in my opinion, a better set of rules. International accounting standards require research costs to be expensed and development costs to be capitalized. Research costs are defined as those R&D costs incurred before technological feasibility has been established. - So those costs that are deemed research are expected to provide possible future benefits which means those costs are expensed and those costs that are determined to be development are probably going to result in future benefits so those costs are capitalized.
- Exactly, so it's not always cut and dried. Some expenditures are expensed immediately and some expenditures are capitalized. That is, they're put on the balance sheet as assets and then expensed over time. And it all depends on management's assessment of the likelihood of future benefit, is it probable?
Skill Level Beginner
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