Construction businesses don’t usually have a choice about paying costs, but contractors may have the choice whether to treat them as an expense on their financials. It’s called capitalization, and it’s not just for grammarians.
What Is Expensing in Construction?
Expensing a construction cost is simply recording the purchase as an expense on the income, or, profit-and-loss (P&L) statement. Let’s look at an example under a traditional double-entry accounting system:
Build-It Construction Co. is invoiced for a $500 equipment rental. They might record a $500 credit to increase their payables account, then a $500 debit to increase a general ledger account that’s dedicated to equipment expenses. As a result, their books balance, and their P&L will show $500 less profit.
What Is Capitalization in Construction?
In construction accounting, to capitalize is to record a purchase as an asset on the balance sheet rather than as an expense on the income statement. The principle here is this: the value paid hasn’t left the company — even if cash has gone out and even if they’ve added debt. By categorizing the purchase as an asset, they’re reporting the value it has for their business.
Therefore, a sample capitalization entry will look different:
Why capitalize? Capitalization allows contractors to recognize a large expense over time rather than as one big negative number on their P&L.
The expense will still show up on financial statements — just gradually. The way this is done is called depreciation for more concrete (“tangible”) assets or amortization for more abstract (“intangible”) assets. These methods systematically move a portion of its dollar value from assets to expenses over its expected useful, or, depreciable life.
In short, capitalizing rather than expensing will show higher profits on the P&L with higher taxes up front.
When to Capitalize Costs During Construction
Generally, companies capitalize when they expect to use the value of a purchase over a long period of time. In other words, they decide that it’s a long-term investment called a capital expenditure. It’ll follow two rules:
- They’ll use the purchase for generating revenue.
- They expect to use it for more than one fiscal period.
Otherwise, a contractor will expense.
For example, Build-It Construction Co.’s equipment rental doesn’t fit those two criteria above. Depending on how they’re recognizing job revenue, lumber or paint used on a regularly invoiced project wouldn’t fit the bill either. All of these are “consumed” during the cost’s reporting period, meaning no value is left over for the company to report. This follows the “matching principle” of accounting, which keeps expenses reported in the same period as the revenues they generate.
If the company buys the equipment outright or even leases it, that’s a different story. It would also be different if they were purchasing or building property for their own business use, such as a warehouse — or even technology like tablets and software. In this case, they might also capitalize related costs, including interest on financing.
Creating a Capitalization Policy
That said, there exists a wealth of fine-grain guidance for contractors to be aware of when creating or applying a capitalization policy. These include FASB standards on when to capitalize, plus GAAP and IRS requirements for the amounts they can expense. There are also safe harbor elections and considerations for whether companies produce audited financial statements.
Construction companies need to have a consistent policy they use to determine when to capitalize during a project. Just as an example, you might require expensing all purchased items below $500. A policy should be the same for both internal bookkeeping and tax reporting purposes. However, contractors may be able to change their policy from one year to the next.
To take advantage of capitalization, the most important thing you can do is talk with your construction CPA about what would make sense for your situation. Lean on their expertise, and make sure you’re doing what makes sense for your business.