What Are the GAAP Capitalization Rules?

Asset capitalization is an accounting method where a cost is recorded as an asset on the balance sheet instead of an expense on the income statement. This treatment is for significant purchases that will provide value to the company for more than one year. By capitalizing a cost, a company reports it as an asset, which allows the cost to be spread over multiple time periods. This approach differs from immediately recognizing the full purchase price as an expense in the period it was incurred.

The standards for these accounting decisions in the United States are the Generally Accepted Accounting Principles (GAAP). GAAP provides a consistent framework that companies follow, which ensures that financial statements are comparable across different companies and reporting periods.

The Core Principle of Capitalization

The foundation of capitalization lies in the matching principle, a concept of accrual accounting. This principle dictates that a company should record expenses in the same period as the revenues they help to generate. This creates a cause-and-effect relationship between spending and earning, ensuring that financial statements accurately reflect a company’s performance.

This principle distinguishes between two types of expenditures: capital expenditures and operating expenses. A capital expenditure is a cost that will benefit the company over multiple future periods, while an operating expense benefits only the current period. For example, when a business purchases a new delivery truck, it is a capital expenditure because it will be used to generate revenue for several years, and its cost is capitalized as an asset.

Conversely, the gasoline used to fuel the truck is an operating expense. The fuel is consumed in the short term to make deliveries and generate revenue in the current period, so its cost is expensed immediately on the income statement.

General Criteria for Capitalizing Costs

For an expenditure to be capitalized under GAAP, it must meet specific conditions that demonstrate a long-term benefit to the company. A primary criterion is that the purchase must have a useful life of more than one year. This rule helps differentiate between short-term expenses and long-term assets.

Another test is whether the cost substantially extends the asset’s useful life or significantly increases its capacity, efficiency, or output quality. For instance, replacing the engine of a delivery truck would likely be capitalized because it prolongs the vehicle’s operational life. In contrast, routine maintenance, such as an oil change for the truck, would be expensed as incurred because these actions do not provide a significant future economic benefit.

Costs are also capitalized when they are necessary to bring a newly acquired asset to its intended working condition. Many companies also establish a capitalization threshold, a minimum dollar amount for an expenditure to be considered for capitalization. For example, a company might set a policy to expense any purchase under $5,000, regardless of its useful life, but this is a company-specific policy for record-keeping convenience and not a rule mandated by GAAP.

Commonly Capitalized Costs for Acquired Assets

When a company acquires a tangible asset, such as a building or machinery, several types of costs are included in its initial capitalized value. These costs are expenditures directly related to the acquisition and preparation of the asset for its intended use. The sum of these costs forms the asset’s cost basis, which is the amount recorded on the balance sheet.

These costs include:

• The invoice price of the asset, which is often reduced by any trade discounts or rebates received.
• Sales taxes paid on the purchase, as they are a direct cost of acquiring the asset.
• Transportation and freight-in costs incurred to ship the asset to the company’s location, including any shipping insurance.
• Installation, assembly, or setup costs required to get it into a usable state, such as building a special foundation.
• Costs associated with trial runs or testing before the asset can be used in production.
• Professional fees directly tied to the acquisition, such as legal fees for a title transfer or appraisal fees.

Special Capitalization Scenarios

Internally Developed Software

GAAP provides specific guidance for software developed by a company for its own use, as outlined in Accounting Standards Codification (ASC) 350. Capitalization of costs begins when two criteria are met: management has committed to funding the project, and it is probable the project will be completed and used as intended. Costs incurred before these criteria are met, such as those for initial project conceptualization and evaluation of alternatives, are expensed as they occur.

Once capitalization starts, direct costs like coding, software design, and testing are recorded as an asset. This can include payroll for employees directly involved in development and fees paid to third-party contractors. Capitalization stops once the software is substantially complete and ready for its intended use. After this point, ongoing costs like training and routine maintenance are expensed, though costs for significant upgrades that add new functionality may be capitalized.

Capitalized Interest

A company can capitalize the interest costs incurred on borrowed funds used to construct a long-term asset for its own use. This guidance, found in ASC 835, allows interest to be treated as a cost of the asset rather than an expense. The principle is that interest incurred during the construction period is a cost necessary to bring the asset to its intended condition.

For interest capitalization to begin, three conditions must be met: expenditures for the asset have been made, activities to get the asset ready are in progress, and interest cost is being incurred. The amount of interest to be capitalized is based on the weighted-average accumulated expenditures for the asset during the construction period. The capitalization period ends when the asset is substantially complete and ready for its intended use.

Any interest costs incurred after this point are expensed as they occur. This rule applies to assets like a new factory or an office building constructed by the company for its operations.

Post-Capitalization Accounting Treatment

Once an asset’s cost has been capitalized and recorded on the balance sheet, the accounting process continues throughout its useful life. The cost is systematically allocated as an expense to the periods in which the asset is used to generate revenue.

Depreciation

For tangible assets, such as buildings, machinery, and vehicles, this allocation process is called depreciation. Depreciation reduces the book value of the asset over its estimated useful life. While several methods for calculating depreciation exist, the straight-line method is common. The calculation involves subtracting the asset’s estimated salvage value—its worth at the end of its useful life—from its capitalized cost and dividing that amount by its useful life.

Amortization

For intangible assets, such as capitalized software costs or patents, the allocation process is known as amortization. Amortization is conceptually similar to depreciation but applies to assets that lack physical substance. The cost of an intangible asset is expensed on a straight-line basis over its legal or estimated useful life. Intangible assets are often assumed to have no salvage value.

Impairment

A separate accounting event that can occur after capitalization is impairment. An asset is considered impaired if its carrying value on the balance sheet is no longer recoverable and exceeds its fair value. This can happen due to unexpected events, such as a significant decline in the asset’s market value or a change in how it is used. When an impairment occurs, the company must write down the value of the asset to its fair value and recognize an impairment loss on the income statement.