![]() The company will consider the cost of the machinery as a capitalized cost on its books. The machine will increase lemonade production and improve overall business efficiency. The business decides to purchase a cutting-edge lemon squeezer. Take the simplified example of running a lemonade stand. Historical costs are a value measure that represents an asset at its original cost on the balance sheet but does not necessarily reflect the current fair value of the asset. The cash on the balance sheet reduces by the amount incurred while the fixed asset section increases by the same amount. ![]() Capitalized costs are recorded on the balance sheet at their historical cost when incurred. As a result, cost capitalization will cause a variation between the reported profit levels on the income statement and the associated cash flows reported on the cash flow statement. ![]() However, the depreciation or amortization relating to the asset is a non-cash expense. It should be noted that the impact of the cash outflow from purchasing the fixed asset is immediate if paid for upfront. The practice of cost capitalization involves depreciating or amortizing the asset over multiple years, which implies it will impact profits for multiple reporting periods into the future. It makes sense to recognize these costs over the asset’s useful life through depreciation or amortization over a long period to match the revenues generated from the assets. However, these long-term assets generate revenue over their entire useful life. The practice of cost capitalization meets the requirements of the matching principle where expenses are recognized at the same time that the revenues generated by those expenses are recognized.įixed assets such as machinery, factory buildings, and land do not generate any revenues when the costs are incurred. As a result, the goal of any business in cost capitalization is to match the cost of an asset to its periods of use when it is generating revenues instead of when the initial cost was incurred. This accounting principle seeks to recognize expenses in the same period as the related revenues. When businesses engage in cost capitalization, they are simply following the matching principle of accounting.
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