Utility bills are listed as expenses on a business's balance sheet. But what if you pay your company's power bill a year in advance? This article talks about converting costs into assets called capitalized costs to make a stronger balance sheet, which can be important in formulating a business plan.
Short Term, Long Term
A short-term cost affects the operating statement, but not the balance sheet (unless losses accrue and negatively affect net worth). Periodic expenses such as payroll, utility bills, rent and the like are examples of short-term costs.
However, some of these expenses can be converted to assets. For that to happen, they must have long-term value and not recur periodically. When paid for in advance, they can become investments.
Say, for example, your company prepays its rent for a year. That amount would show on the balance sheet as an asset. If the rent was $1,000 per month and paid a year in advance, the balance sheet would show a $12,000 asset.
Of course, the $12,000 prepaid asset would diminish by $1,000 each month.
Expensive Items: Capitalized Costs
Equipment is another example of a capitalized cost on a balance sheet.
Say the business writes a check for a computer, which will clearly last more than a year. The amount of that check may be a cost, but it's paying for a long-term asset—the computer—which will show on the balance sheet. This is another example of a cost becoming capitalized.
Years ago, while working as a buyer of women's sportswear for a small-town department store, we bought a line of wool trousers for $25 per pair. Saks Fifth Avenue bought the same product. We sold the trousers for $50 a pair. Saks sold them for $70. Which product had more "worth" to a customer, ours or Saks'?
The above is an example of branding. Saks had developed an international reputation for quality and could trade on that. What did branding development cost Saks? A few days of an artist's time? Newspaper and other advertising?
All of these and more. Yet each of these items was a short-term cost. Yet all of these items add up to a huge item on Saks' balance sheet—goodwill. This is an intangible asset made up of capitalized costs.
It takes years of expenses to create goodwill as a capital asset, but it's of critical importance in a business plan's strategy.
Depreciation and Writeoffs
Expensive items such as boats, heavy machines or buildings have "useful lives" in accounting terms, and must be depreciated accordingly. Useful lives are usually stated in years. A computer may have a useful life of three years, for example. If so, it depreciates 1/36 of its value each month, and this depreciation amount will be shown as a monthly expense.
But the item's cost is still capitalized.
Does Borrowed Money Have an Effect?
Some costly items, such as trucks, may be purchased with loan proceeds. In this case, the loan will appear as a long-term liability and the truck as an asset whose cost has been capitalized. Only the portion of the loan payable within a year will be classified as a short-term liability. Depreciation also must be used.
The capitalized cost is not affected.