Capitalization
In the IRS uniform capitalization rules, there are both questions and answers for how to identify costs subject to capitalization. Still determining the capitalization requirement and determining which costs would be deductible are difficult at best. Everything depends on the how the corporation was formed or expanded and what combination of contributions or debt proceeds financed them (Simonds, 2006). In this paper, I will answer the questions; How is taxable income calculated with respect to capitalization of costs? What are the characteristics of an expense for it to be capitalized? What is the principle behind capitalizing expenses? Should you capitalize cost for the sole purpose of minimizing the organization’s tax burden?
How is taxable income calculated with respect to capitalization of costs?
When capitalizing the net operating income of an organization in the income approach, the flotation-cost adjustment may not apply to the cost of capital. The reason for that is because the advocate of its adjustment might be confusing or interfering with the conception of the allowable rate of return which arises from the invested capital (Simonds, 2006). This also is in line with the market-determined opportunities which determine the cost of the invested capital. Therefore, in computing taxable income with respect to the capitalization of costs, the following formula holds;
Taxable income = gross sales – (permissible deductions + other operating expenses)
What are the characteristics of an expense for it to be capitalized?
As much as capitalization is concerned, accepting the accounting principles demands the general capitalization of costs whenever the existence of future benefits was to be expected from expenditures. For example, in case a business organization decides to buy a building, the income to be realized from it is expected to increase in the future. Another characteristic is that any interest expense incurred in the production process is always capitalized on the balance sheet.
Conversely, since capitalization of a business enterprise begins with the valuation of the interest expenses incurred, this procedure only ends when assets are substantially valuated and readily available for the intended purpose (Pratt & Grabowski, 2011). Moreover, expenses are usually booked in case a business enterprise has no ability of capitalizing costs.
Additionally, capitalization of expenses usually has to meet relatively all the requirements of matching principle. The reason for that is because it assists in recognizing expenses as well as the revenues such expenses managed to generate.
What is the principle behind capitalizing expenses?
Typically, an expense is the monetary value which leaves a business organization. This includes things like payment of electricity and water bills, rent, and so on. As a result of that, during the application of the income capitalization procedure, it is essential to ensure that the estimation cost is adjusted so as to fit the floatation costs. Often, market value is represented by the future cash flow of present value (PV) of a business enterprise. The reason for that is because it is the one that represents or results to the zero net present value (NPV) investment following the allowable floatation costs and investment (Pratt & Grabowski, 2011).
In addition to that, matching principle of capitalizing expenses entails matching them with revenues. Consequently, the period of incurring costs ought to be matched with the assets. Furthermore, it should be noted that assets have usually had long lives hence in return generates revenue during the useful lifetime of an organization (Werner & Stoner, 2010). Likewise expenses ought to be amortized over a long period of time.
With respect to the capitalization principle and actual business operating period, direct costs, and indirect costs must be capitalized together during the pre-production and sale period. The reason for that is because direct and indirect expenses are basically capitalized for only the production period.
Should you capitalize cost for the sole purpose of minimizing the organization’s tax burden?
It is evident that costs can be capitalized for the sole purpose of minimizing the organization’s tax burden. As stated above, capitalization involves the recording of the items in the balance sheet account as compared to that recorded in the income statement (Werner & Stoner, 2010). Therefore, capitalized costs are normally recognized as being as being part and parcel of the fixed asset on a business enterprise’s balance sheet and not charged expenses for that operating period. Nonetheless, the reason for that consideration is because capitalization is mainly used whenever an item is perceived to be utilized over a prolonged period (Pratt & Grabowski, 2011). For instance, in case costs are to be capitalized, it means that they will have to be charged over a period of time through depreciation of the tangible assets and amortization of the intangible assets.
On the other hand, due to the fact that capitalization of costs is normally amortized or depreciated over several years, it implies that it will have a long-term impact on the profits to be realized for several reporting years into the future (Werner & Stoner, 2010). Regardless of that, the associated impacts of cash flow are deemed as being immediate if only the costs incurred are to be paid for up front. Consequently, subsequent amortization or depreciation becomes a non-financial expense of the organization
References
Simonds, R. (2006). Income Capitalization, Flotation Costs, and the Cost of Capital. Journal of Property Tax Assessment & Administration, 3(4), 23-29.
Pratt, S. P., & Grabowski, R. J. (2011). Cost of capital in litigation: Applications and examples. (Cost of Capital in Litigation.) Hoboken, N.J: Wiley.
Werner, F. M., & Stoner, J. A. F. (2010). Modern financial managing: Continuity and change. St. Paul, MN: Freeload Press.
