The capitalized cost of an asset, step by step

When a business buys a machine, a building or a piece of land, the price on the invoice is rarely the whole story. Shipping, installation, legal fees and site work all come with it. Some of these costs become part of the asset, and some are ordinary expenses. This page explains the rule that decides which is which, works through four examples, and covers the mistakes that cause most wrong answers.

What "capitalize" means

To capitalize a cost is to record it as part of an asset on the balance sheet instead of as an expense on the income statement. A capitalized cost does not reduce profit right away. For assets that wear out, such as equipment and buildings, it reaches the income statement gradually through depreciation over the years the asset is used. For land, which is not depreciated, it stays on the balance sheet until the land is sold.

To expense a cost is to record it as a cost of the current period. It reduces this period's profit in full.

The choice matters because it changes both statements. Expense a cost that belongs to the asset, and this year's profit is too low while the asset is understated for years. Capitalize a cost that is really an expense, and profit is too high now while the asset is overstated.

The rule: everything needed to get the asset ready for use

The cost of a long-term asset is everything the business reasonably and necessarily spends to acquire it and get it to the place and condition where it can be used as intended. That one sentence answers almost every question:

• Equipment: the purchase price, freight to your premises, insurance while it is in transit, installation, assembly and test runs before it goes into service.
• Land: the purchase price, legal and title fees, real estate commissions, the cost of clearing or demolishing old structures, and grading or leveling the ground.
• Buildings: the purchase price or construction cost, permits, architect fees and the cost of preparing the building for its intended use.

Costs that come after the asset is ready, or that do not help get it ready, are not part of its cost. Insurance for the months the machine is running, routine maintenance, and repairs of damage you caused yourself all fall outside the rule.

Two questions settle most cases. First: was this cost necessary to get the asset ready? Second: does it relate to acquiring the asset, or to using it? A cost that passes the first and relates to acquiring the asset is capitalized. Anything else is an expense or, if it covers future periods, a prepaid asset.

Worked example 1: shipping and installation

Copperleaf Studio bought a large-format printer for $51,150.00. It also paid $500.00 to have the printer shipped to its premises and $835.00 to have it installed. Everything was paid in cash.

The printer could not be used without being delivered and installed, so both costs are part of its cost:

$51,150.00 + $500.00 + $835.00 = $52,485.00

Equipment is recorded at $52,485.00, and that is the figure depreciation starts from. If you later work out the yearly depreciation on this printer, the shipping and installation are spread over its useful life along with the price. The depreciation journal entry page shows how that works.

Worked example 2: sorting a mixed list of costs

Real purchases come with a pile of bills. Copperleaf Studio bought a laser cutter and paid these amounts in cash:

Price, shipping, installation and test runs were all needed to get the cutter working, so they total:

$53,150.00 + $655.00 + $2,615.00 + $660.00 = $57,080.00

The repair was not needed to get the machine ready. It fixed a mistake the business made, and the machine is no more useful afterwards than it would have been without the accident. That is an expense of the period.

The insurance covers the year in which the cutter is used, not its journey to the shop. It is a cost of operating the machine. Because it is paid in advance for twelve future months, it is recorded as Prepaid Insurance and expensed month by month.

The credit to Cash is the total paid, $58,168.00. The entry balances, and each cost sits in the account that describes what it really is.

Worked example 3: the cost of land

Northside Print Shop bought a lot to build a new store on. It paid in cash: $370,000.00 for the land, $2,400.00 in legal and title fees, $8,100.00 to tear down an old shed on the lot, and $7,100.00 to level the ground.

Every one of these costs was spent to get the land ready to build on. The fees were needed to acquire it. The demolition and leveling prepared it for its intended use. So all of them go to Land:

$370,000.00 + $2,400.00 + $8,100.00 + $7,100.00 = $387,600.00

The old shed is a common trap. It was a building, but the business did not buy it to use; it bought the lot and paid to clear it. The cost of removing it belongs to the land, not to Buildings. The new store, once built, will be recorded in Buildings at its own construction cost.

Worked example 4: a lump-sum purchase

Sometimes a business buys several assets together for one price. Pine Street Dental bought land with a building on it for $403,000.00 in cash. An appraiser valued the land at $125,000.00 and the building at $349,000.00.

Land and buildings must be recorded separately, because buildings are depreciated and land is not. The price is split in proportion to the appraised values. First find the land's share of the total appraisal:

$125,000.00 ÷ ($125,000.00 + $349,000.00) = $125,000.00 ÷ $474,000.00

Then apply that share to the price actually paid, rounding to the nearest cent:

$403,000.00 × $125,000.00 ÷ $474,000.00 = $106,276.37

The building gets the rest of the price, so the two parts add back to exactly what was paid:

$403,000.00 − $106,276.37 = $296,723.63

Working out the building's share as the remainder, instead of rounding a second calculation, avoids a one-cent gap between the debits and the credit.

Common mistakes and how to avoid them

Each mistake below is one that our exercises catch and explain.

Expensing shipping and installation

It is tempting to treat freight and installation as everyday operating costs. They are not: without them the asset cannot be used. In the Copperleaf printer example, debiting $51,150.00 to Equipment and $1,335.00 to an expense account understates the printer's cost. Add the extras to Equipment.

Recording only the price

A related slip is to record the invoice price and forget the other payments altogether. Recording $51,150.00 for both the debit and the credit leaves out $1,335.00 of cash that really was paid. The credit to Cash must match everything paid, and the debit to Equipment must include all of it.

Capitalizing everything

The opposite error is to put every payment connected with the asset into its cost. In the laser cutter example, debiting all $58,168.00 to Equipment wrongly includes the repair and the insurance. Ask of each cost whether it was needed to get the machine ready. Only those costs go to Equipment.

Capitalizing a repair you caused

Fixing damage your own staff caused does not make the asset more useful than it would otherwise have been. Recording Equipment at $57,400.00 instead of $57,080.00 hides a cost of carelessness inside the asset. Debit Repairs Expense for $320.00.

Putting only the price in Land

Legal fees, demolition and grading prepare land for use, so they are part of its cost. In the Northside example, sending $17,600.00 to an expense account leaves Land at $370,000.00, too low by everything spent to get the lot ready.

Debiting Buildings for the cost of a cleared lot

When the business buys land and tears down what is on it, there is no building to record. All the costs, including the demolition, belong to Land.

Recording appraised values

In a lump-sum purchase the appraisals tell you how to split the price; they are not the cost. Recording $125,000.00 and $349,000.00 would put $474,000.00 of assets on the books when only $403,000.00 was paid. Assets are recorded at what they cost, not at what someone says they are worth.

Putting the whole price into Buildings

Land and buildings are separate assets, and land is not depreciated. If the full $403,000.00 goes to Buildings, the business will depreciate the land's share by mistake for years. Split the price by the appraised values.

Capitalized cost and later spending

Once an asset is in service, the same thinking applies to new spending on it. Routine maintenance and ordinary repairs keep the asset working as it was, so they are expensed. A major improvement that extends the asset's life or increases what it can do is usually capitalized. The examples on this page focus on the purchase itself, but the test is the same: does this cost buy future usefulness, or does it just keep the asset as it was?

A quick routine for any capitalized cost question

1. List every payment connected with the purchase.
2. For each one, ask: was it necessary to acquire the asset and get it ready for use? If yes, it goes to the asset.
3. For the rest, decide whether it is an expense of this period (a repair you caused, routine upkeep) or a prepayment for future periods (insurance paid in advance).
4. For a lump-sum purchase, split the price by the appraised values and give the last asset the remainder.
5. Credit Cash, or the liability, for the total paid, and check that the entry balances.

After the asset is recorded, its cost drives depreciation each year and, eventually, the gain or loss when it is retired. The sale of equipment journal entry page picks up the story at the end of the asset's life.