When I was learning how to read financial statements I couldn’t quite grasp the concept of “capitalizing costs” to the balance sheet. Because there might be other investors out there going through the same difficulties, I’ll try to shed some light into this subject.

In the normal course of its operations, a company incurs in several different costs and expenses. (A cost is usually considered a transaction of money for an asset while an expense is usually money leaving the company for something readily consumed like rent or an electricity bill. For the sake of simplicity I’ll assume that they are the same).

The costs which are deemed to bring a short-term benefit to the company are recognized or “expensed” in the Income Statement immediately. These could be salaries, rents, transportation costs, advertising costs, administrative costs, etc.

The same doesn’t happen when those costs are deemed to bring a future or long-term benefit to the company. Examples of these would be a new factory, new machinery, etc.

Whenever a company incurs in costs that will bring benefits for several years to come, accounting rules state that those costs should be “capitalized”. Capitalize a cost means that instead of reporting it immediately on the income statement, the company should create a new asset on the balance sheet for the full amount expensed.

This will be recognized immediately on the Cash Flow statement as “Capital Expenditures” (also called “CAPEX”) but not on the income statement.

Consequently, this new asset will be depreciated or amortized throughout its useful life. What does this mean?

It means that there will be a depreciation charge in the Income Statement which will have the effect of lowering profits every year until the asset is completely written off the Balance sheet. Why does this happen?

This happens to try to smooth out those costs and match them with the length of time in which the asset will be generating revenue.

Of course, this close relation between costs and assets can sometimes lead to less desirable situations. Companies in need of a little boost to their earnings might capitalize some of the current expenses, effectively inflating profits in the current period. The other side of the coin is that those capitalized costs will be lowering future profits.

I hope this helps some of you that are just starting to learn about investing and finance. If there’s any other concept that you might be struggling with, just post it on the Facebook group so other more experienced investors can help you out. Don’t be afraid. Learn something new every day.