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Comparing the Effects of Capitalizing & Expensing

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  • 0:01 Expenses
  • 0:45 Expensing
  • 1:25 Capitalizing
  • 4:33 Lesson Summary
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

What does it mean to capitalize a purchase instead of expensing it? And how do you know which one to do? View this lesson to find out more about capitalization and the ways to know whether to capitalize or expense.

Expenses

Judy owns a spa. She has to buy lots of equipment for her spa, as well as things like body lotions, scrubs, and oils. She's heard that doing something called capitalization of her expenses can help make her company more profitable, but she isn't sure what that is or how to do it.

Every company has to spend money. Whether it's on things like massage tables and robes, like Judy's spa, or raw materials to manufacture cars, or just a computer and Internet access, every company has expenses.

To help answer Judy's question, let's look closer at expensing versus capitalizing and when to do each.

Expensing

Judy has a lot of expenses. Every month, she has to buy large quantities of lotions, scrubs, and oils. Her spa also offers manicures, so she has to buy nail polish, not to mention office supplies like paper, pens, and printer ink.

Expensing an item means calling it an expense and marking it against the profits at the time it is purchased. For example, if Judy makes $100,000 in a month but spends $40,000 on supplies, then expensing the cost of her supplies would bring down her spa's possible profit to $60,000 for that month. And that's before costs like the wages of the people who work for her.

Capitalizing

As you can see, expensing items can make a company's profits seem to disappear. Is there a way that Judy could make the profits of her company look better on paper?

For some expenses, Judy might choose capitalizing, or delineating an item as an asset, over expensing. In this case, an asset is something that adds value to a company through the possibility of future value, whereas an expense is just something that costs the company money in an effort to generate revenue.

There are two values to capitalizing an expense. First, it can make the company appear more profitable on paper, which is particularly valuable if she wants to borrow money from the bank or sell stock shares in her company. Second, there's more flexibility as far as taxes go.

Let's look at the example from above. Judy makes $100,000 but has to spend $40,000. If she expenses the items she purchased, she has to subtract the $40,000 from the $100,000 when she purchases.

But let's say that instead she capitalizes the items. She now has $40,000 in assets plus the $100,000 her company earned that month. Together that's $140,000 on the gains side of the balance sheet in that month. When she subtracts the cost of the items, she ends up with $100,000 instead of $60,000.

In addition, Judy can choose to spread the cost of capitalized assets over several months or even years. She can also put the depreciation of assets against her tax bill, potentially saving her company money on taxes.

That sounds pretty awesome, right? You might be thinking that Judy should capitalize everything from now on. But wait! Not everything is an asset, and there are some things that Judy has to expense or she risks ending up on the wrong side of regulations and laws.

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