Your accounting system shows how your business earns and spends money, but the correlation between the purchases you make and the journal entries you create isn't always entirely straightforward. Some expenditures are expensed and appear on your books in ways that directly reflect the money you spent. Other expenditures are capitalized, using a convention that shows both the fact that you spent money and the fact that, as a result of this purchase, you now own something that makes your business more valuable.
An expenditure is expensed in accounting when you enter it in your books simply as outgoing cash exchanged for something your business will use up quickly.
Most of your day-to-day operating costs are expensed because they flow through your business and are depleted during day-to-day operations.
- Payroll costs cover worker hours, which are expensed because your employees take their checks and go home rather than reinvesting those earnings in your company.
- Materials costs are expensed because they go into products that you intend to sell soon.
- Expensed repairs simply return your equipment to the state it was in before it was broken.
Another way to think of expensed costs is that they don't add any future value to your business. You pay rent whether or not your business produces anything or earns any profit. You can't recoup your rent money once you've spent it. Similarly, utilities are used up and then billed, and delivery expenses are used and finished during normal business operations.
A capitalized cost is entered into your accounting system differently than one that is expensed. Large purchases are more likely to be capitalized than small ones, especially significant investments such as property and expensive equipment. A capitalized cost affects your balance sheet because not only do you deplete funds by spending them, but you also add to your assets by purchasing the items that are capitalized because they have enduring value.
While items that are expensed are usually noted in your bookkeeping as straightforward expenditures, capitalized costs are more often depreciated or deducted in increments over time. The depreciation period you choose should correspond with the useful life of the items you acquire, such as five years for computers and eight years for most automobiles.
Once you determine the depreciation period for an asset, divide the total amount you spent by the number of years in the depreciation period and deduct that percentage of its value each year until the asset is fully depreciated.
Although the items you capitalize or depreciate can only be treated as deductible expenses over time, you still have to finance these purchases when you pay for them, either by paying cash up front or taking out a loan. For accounting and tax purposes, your reported expenditures are based on the depreciation period whether you pay for your equipment up front or in monthly loan installments.
If you do take out a loan, your interest payments are tax deductible, but they are expenses separate from the cost of the capitalized equipment. The interest you pay is expensed rather than capitalized because it adds nothing to the overall value of your business.
When you expense business purchases, you typically pay for them in a time frame that corresponds to how they appear on your books. If you buy paper and paperclips at the beginning of January and pay for them when you buy them, your journal entry will correspond with the expenditure.
However, if you need office supplies and you're short on cash, you may use a credit card to pay. Your bookkeeping entries will correspond to the date that money changed hands between you and the office supply store. The principal that you pay on your credit card bill to cover these office supply purchases isn't a deductible expense because you've already expensed these supplies. However, the interest you pay is deductible because you accrue it after the fact.