Rules for Capitalizing & Amortizing Costs

Amortization is sometimes used as an interchangeable term for depreciation.

One of the most important rules in accounting, the Matching Principle, requires that expenses be recorded in the same time periods as the revenues that their occurrence helped produce. Since assets lose their usefulness and thus value through usage in business operations to produce revenue, those losses must be recorded as expenses in each time period of their usage in a process called depreciation. Certain expenditures that produce benefits across multiple time periods are recorded as assets on the same principle and their value deducted across those time periods in a similar process called amortization.

Capital and Revenue Expenditures

Businesses must incur expenditures to run their revenue-producing operations. Expenditures can be divided into either capital or revenue expenditures. Revenue expenditures, more often called expenses, benefit the business in the single time period of their occurrence. In contrast, capital expenditures produce benefits across multiple time periods.

Capitalization

Since the Matching Principle requires that revenues and expenses to be recorded together in the same time periods based on their causal relationships, capital expenditures must be recorded as assets so that their values can be expensed across multiple time periods. Capital expenditures are either added onto preexisting tangible assets or recorded as intangible assets and then either depreciated or amortized as the case might be.

Capitalized Costs

For capital expenditures that increase the usefulness of a preexisting asset, their values are added onto that asset to be depreciated or amortized as the case might be. For capital expenditures that do not increase the usefulness of a preexisting asset, their values are recorded as intangible assets to be amortized across the periods of their usefulness. For example, if the business spent $2,000 to upgrade a vehicle, that $2,000 is added onto the value of the vehicle to be depreciated alongside the vehicle. In contrast, if that same business spent $40,000 in research and development costs that benefit it across multiple time periods, it records the $40,000 as an intangible asset called research and development to be amortized.

Amortization of Capitalized Costs

Amortization and depreciation are both used to depict the decline in value incurred through usage on the accounting ledger, but for different accounts. Amortization depicts this process for intangible assets while depreciation depicts the same process for tangible assets. In practice, a portion of the asset’s value is calculated to be lost through its usage in each time period until that asset’s usefulness is concluded and its value exhausted. Different methods exist to calculate the portion to be deducted in each time period and different methods are better suited to different assets. One example is the straight-line method, which allocates an equal portion of the asset’s value as amortization/depreciation expense in each time period that makes up its useful lifespan.

References

• IAS Plus: IAS 18, Revenue
• IAS Plus: IAS 38, Intangible Assets
• AccountingCoach: Depreciation