As you run a small business on your own, you have to decide on many things. Deciding how your business deals with the costs can be one of those decisions. When your firm spends money, you can choose to manage the costs as a capitalising cost or an expending cost (Also see Characteristics of Successful Business Owners).
Capitalizing and expending of costs describe the ways you can treat costs on the financial statements of your business. If you decide to expense the incurred cost, you have to include the expenditure to your firm’s income statement and deduct the identical amount from your firm’s income to identify profit (Also see How Can Good Accountants Help in Growing Your Business and Reducing Your Expenses).
On the other hand, if you decide to capitalize the cost, it will be part of your business capital spending. This indicates that you will record the cost as an asset in the firm’s balance sheet (Also see How does the Balance Sheet relate to Profit and Loss?). Keep in mind that you should work out the value of depreciation related to the asset and include this value in the firm’s income statement. When you produce a cash flow statement, you have to record the cost as cash outflow for investments.
Impacts of Expending Costs
Listed below are some ways the expenditure which is classify as an expense would affect your financial statements of your firm during the accounting period you incur the expense.
- You do not have to make an entry in your business balance sheet
- Your firm’s net income will reduce. Keep in mind that lesser net income is going to cause retained earnings to be low too.
- It will cause the cash inflow coming from operating activities to decline since expenses are cash outflow from the process of business operations
- In the current years, ROA and ROE will be low. However, both of them will gain in the upcoming years.
Impacts of Capitalising Cost
When you capitalize the business costs, they will influence your firm’s financial statements within the accounting period you incur them. Listed below are several ways cost capitalization would influence the financial statements of your firm.
- The amount of assets in the business’s balance sheet as well as the sum of cash flow from operating activities will increase
- Cost capitalisation leads to a greater profitability. Keep in mind that this effect of a boost in the profitability and this carries on until the capital expenditure exceeds depreciation
- It results in higher ROA and ROE in the current accounting period, but this will decrease in the upcoming years
- In the next accounting periods, capitalising the cost will cause the following to happen in your financial statements.
- The sum of cost that you capitalize should be dispensed over the asset’s estimated lifespan as depreciation.
- Because of the depreciation, the net income and value of the asset will decrease
- As depreciation (Also see definition of depreciation and impairment) is not a cash expenditure, it has no effect on the cash flow statement
Expending costs of the business decreases its short-term profitability but in the upcoming years, the tendency will improve. Conversely, the short-term profitability will increase if you capitalize a cost. As both capitalising and expending cost have their own pros and cons, you must make comparisons between them and select the method which is the most suitable for you by hiring an accounting firm in Johor Bahru to get assistance.