Question

How is taxable income calculated in 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?

Answer 1

Hey,

Let's understand all your queries with an example. Say you go to purchase a car, you pay money to the dealer and get it registered in your name. You paid money so it is an expense right? Will you charge this full amount what you paid as an expense?

Basic Principle behind capitalization is that the expense which you have done today will be used for many years and so you must not charge it in the same period. Let me extend the example, you use your car to transport goods and you earn revenue from it, now matching the concept of accountancy says that income earned must match with the expense done. Imagine whole car expense you have charged in 1st year, in 2nd, 3rd etc years you won't have expense but will surely have income right?

Hope this Explanation helps you understand the concept.

Basically, due to the Capitalised cost, the impact on taxable income will be that it will not reduce the income directly in the first year. Deduction in form of depreciation will be done every year based on the usage of the asset, this will also match the matching concept of accountancy.

The main Characteristic of Capital Expense is that it will be used for a Long time, by the Long time it means more than one year.

The principle behind Capitalising Expense is matching principle as I discussed above, matching the expense with the income for the period.

No the purpose of capitalization is not to minimize the tax burden, the purpose is to present the financial statement fairly. Rather if we don't capitalize the expense then we would have charged it in the year we incurred the expense which would have minimized income in the very first year resulting in lower tax burden.