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A capitalized cost is any type of additional expense that is applied to the cost basis of a fixed asset. Many businesses utilize this approach when it comes to financing the purchase of fixed assets, or even when creating or building a fixed asset, such as the construction of a shopping mall or an office building. One of the characteristics of capitalized cost is that the expense is not applied just to the time period in which it was incurred. This type of expense is realized incrementally over a longer time frame, usually due to factors such as amortization or depreciation.
The addition of a capitalized cost appears on the balance sheet, and is directly related to an existing fixed asset. This process makes it possible to relate the expenses associated with that asset to the revenue that is generated by holding or controlling an asset such as real estate or a building. Since fixed assets tend to provide consistent use over many years, it is important to amortize the costs of those assets, keeping in mind the revenue that is produced by the use of that asset.
A basic example of a capitalized cost would be the construction of a new manufacturing plant. During the course of building the facility, significant expense takes place in terms of building materials, the labor required to construct the plant, and the financing that the owner obtains to fund the project. Those expenses are related to the plant as a fixed asset, and are taken into consideration when determining the overall costs associated with owning the plant. Tracking the costs makes it easier to determine if the revenue generated once the building is complete and occupied is sufficient to offset those expenses, as well as the ongoing costs of maintaining the structure. Since the detail is tracked on the balance sheet of the owner’s accounting records, it is easy to determine when the project has generated enough revenue to cover the costs of the construction, and is generating enough ongoing income to take care of the maintenance and upkeep of the plant.
Associating a capitalized cost with a specific fixed asset is also important when it comes to claiming depreciation of that asset for tax purposes. That depreciation may be used to help decrease total tax liability, by offsetting a portion of the revenue generated. The exact mechanisms used to claim depreciation will vary from one nation to the next, based on current regulations and standards put in place by the tax or revenue agency that is operated by that national government.
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