What costs do we capitalize when purchasing assets? How does owning an asset and taking annual depreciation help business net income?

A capitalized cost is a cost that is incurred in the purchase of a fixed asset that is expected to directly produce an economic benefit beyond one year or a company’s normal operating cycle.Capitalized costs are incurred when building or purchasing fixed assets.

Capitalized costs are not expensed in the period they were incurred but recognized over a period of time via depreciation or amortization.The purpose of capitalizing costs is to better line up the cost of using an asset with the length of time in which the asset is generating revenue.

All expenses incurred to bring an asset to a condition where it can be used is capitalized as part of the asset.

Examples of Capitalized Costs

Many different costs can be classified as capitalized costs when purchasing assets, they include:

• Sales taxes related to assets purchased for use in a fixed asset

• cost of purchased asset

• Interest incurred on the financing needed to construct an asset

• Transport costs incurred to bring a purchased asset to its intended location

• Testing costs incurred to ensure that an asset is ready for its intended use

Capitalized costs are initially recorded on the balance sheet at their historical cost. Historical costs are a value of measure that represents an asset at its original cost on the balance sheet. It does not necessarily reflect the current fair value of the asset.

Depreciation is used in accounting as a means of allocating the cost of an item, usually a tangible asset, over its life expectancy. In its essence, it represents how much of an asset's value has been used up over a specific period of time.

Net income is the amount left over after all cost of goods sold, operating expenses, selling, general, and administrative expenses, depreciation, interest, taxes, and any other expenses have been accounted for. It is the net earnings of a company. Depreciation allows a company to spread the cost of an asset over its useful life, which avoids having to incur a significant cost from being charged when the asset is initially purchased. It is an accounting measure that allows a company to earn revenue from an asset, and pay for it over the time it is used. As a result, the amount of depreciation expensed reduces the net income of a company.

Depreciating assets give you more income on your profit and loss statement and increase your assets on your balance sheet. For instance, you bought a computer system in 2017 for $5,000. The life of a computer is 5 years, so you will get a write-off the $5,000 over the next five years (taking the expense to reduce your business taxes). The computer you bought in 2017 for $5,000 less the depreciation of $1,000 taken in 2017 leaves a net income of $4,000 and increases your assets on your balance sheet by the same $4,000. Any third party looking at a business’ financial statements likes to see increased net income and an increase in assets over liabilities.