Capitalized Costs

Capitalized expenses vs operating expenses: how some expenses increase the value of your assets.

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Over the course of your business you are going to make purchases. Some purchases are going to be long-term business assets; others are going to be short-term, quickly used up. For example, if you are putting a new roof on your building, you are extending the life of your building. While it is a quote-unquote “expense” to put the new roof on your building, it is a capitalized expense because it is giving an added value to your building: it is extending the life of your building. And you are going to keep these capitalized costs, capitalized expenses, differently than you would treat typical operating expenses. An operating expense to the same building that you are working in: you may paint it. Now, painting does not increase the value, it maintains the value, and is just in the general course of operating a building. So that expense is going to be on your income statement, it is going to be an operating expense.

What is the difference between a capital expense and an operating expense? Well, two things. First of all, a capital expense is going appear on your balance sheet, meaning that you have increased the value of your assets, so therefore its representation will be on the balance sheet. An operating expense, on the other hand, is going to show up on the income statement. Well, why does this matter? If you use it as an operating expense, that means that your income is going to be lower, because your expenses are higher. If you capitalize, it means that your expenses on the income statement are going to be lower and you are going to show a higher profit.

When you capitalize expenses, you can depreciate them, and that means that you are basically spreading out the cost of the expense, the impact on your income statement, over several years. That is how depreciation works: it is spreading the expense over a couple of years. If you are getting value, let’s say out of a display case that you buy for a jewelry store, you are getting the use of that display case for many years, so you want to show the impact of that expense over many years and not just on the day that you buy it. So that is the difference between capital and operating costs, how they appear on your financial statements, whether they are on the balance sheet or the income statement, whether they are depreciated, and their impact on your operating profit.

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