Capitalized costs

Capitalized costs are spending that a company records as an asset on the balance sheet instead of as an expense on the income statement right away. The cost is then spread over the years the asset is expected to bring a benefit, through depreciation for physical assets and amortization for intangible ones. Buying a machine is the plain case. The judgment calls come with internal spending, such as developer salaries (see capitalized software) or interest on money borrowed to fund a construction project (see capitalized interest).

Accounting rules set when a cost may be capitalized: it has to create a benefit that lasts beyond the current period, and for internal projects only some stages qualify. Within those rules management still makes estimates, such as when a project became likely to succeed and how long the resulting asset will last, and those choices move reported profit.

Capitalizing a cost raises earnings today and lowers them in later years as the asset is depreciated or amortized. The cash leaves either way, but it is reported as investing cash flow instead of operating cash flow, so operating cash flow and EBITDA look stronger too. When comparing companies, check the notes for how much each one capitalizes and whether that amount is growing faster than revenue, and look at free cash flow after subtracting all capital spending, capitalized software included, which counts the cash however it was recorded.