There are two types of expenses in accounting -- expenses expected to help the company generate revenue in the current period and expenses expected to help the company generate revenue in future periods. The one type of expense is expensed, while the other type of expense is capitalized and depreciated over a period of time. Understanding the difference will help you identify a potential investment opportunity as well as understand the earnings power of a company.
Under generally accepted accounting principles (GAAP), a company is supposed to expense an item if it is a normal, day-to-day expense for the business. These are usually expenses such as rent, utilities, inventory, and selling, general and administrative. The expensing of an item occurs when the whole cost amount is placed on the income statement.
Most of the expenses in accounting are expensed. If a company spends money on wages and salary, those items will be placed on the income statement at the stated cost and all subtracted from revenue in the calculation of earnings. Other items such as research and development and marketing expense are also expensed, although there are some exceptions for software companies that have heavy research and development costs.
The other type of expenses are capitalized. Assets that are purchased and are expected to generate revenues for the company in future years, such as property, plant, and equipment, are capitalized on the balance sheet. The process of recording capitalized expenses on the balance sheet involves placing the total cost of the item on the balance sheet. If the asset is subject to depreciation, a company has to depreciate it or take a certain expense charge on its income statement for the duration of the useful life of the asset. For example, if a company buys a piece of equipment for $5 million and its useful life is five years, the company will have to depreciate the equipment at a rate of $1 million a year.
If a company spends $50 on pencils, which is a supply in its office, the company would place the entire $50 amount on its income statement and subtract it from revenue, just like all the other expense items. If a company spends $5 million on new equipment, the equipment would be capitalized and depreciated over the useful life tables provided by accountants.
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