Not all costs are created equal. Within each project, you will have costs that are used within a short period and long-term investments that benefit your business for years. This is the difference between capitalized and expensed projects: a capitalized project will provide value for much longer.
Understanding when you should expense or capitalize costs can help you better track your construction operating expenses. Healthy accounting practices can help you forecast costs and ensure your business stays profitable. Learn more about these two concepts and how to use them.
What Costs Are Capitalized During Construction? Criteria and Considerations
The main thing to ask when capitalizing costs is if the purchase will be useful for more than a year. For example, the tablet that you buy to report on projects and take notes on their progress should last around five years, making it a valuable cost to capitalize.
Construction firms purchase a variety of assets that help them throughout the years. If you buy equipment instead of renting it, you are capitalizing a a purchase. The fleet vehicles, software tools, and office space you purchase are all capitalized because they provide long-term value.
Capitalized investments are usually soft costs, which means they support the business as a whole. This is different from hard costs that are related to specific projects. In construction, you might invest in a specialty piece of equipment for one project but then use it for various other projects throughout the years.
Long-term Benefits and Asset Creation
Capitalization refers to assets that provide long-term benefits to organizations. As your business grows, you can build your assets by investing in equipment, tools, and technology to make the work faster and easier.
For example, a contractor could offer painting services with just a few rollers and brushes. However, as their business grows, they can invest in sprayers, texture applicators, and more advanced tools that provide better results for customers. These investments will also make their work less laborious.
One thing to remember as you capitalize costs is that they depreciate. The equipment you use will wear out and break over time. You can track the value of the cost as it depreciates until you dispose of it or sell the asset.
Capitalization Thresholds and Policy Considerations
Not every item should be capitalized. Just because you bought printer paper in bulk for your office that lasted two years doesn’t mean it is an asset. A capitalization threshold is a set amount to determine whether an item should be recorded as an asset. These thresholds vary by company size, are determined by the business, and may be based on current finances. A small business might set a threshold at $1,000 while an enterprise only capitalizes investments over $10,000.
Develop a consistent capitalization policy within your business to ensure everyone is on the same pace for what should be considered an asset. This will keep your books more organized and guide your purchasing decisions.
When to Expense Costs
Companies should expense costs when they will be used immediately and will only provide short-term benefits, which means they last less than a year. Recording these expenses promptly will keep your books organized and allow for accurate tax filing.
Construction companies often expense permits because they are only used for specific projects. They will expense any equipment they rent instead of buying and the transportation costs related to the work. Repairs on your assets can also be considered expenses.
Impact on Profitability and Tax Implications
Expense reporting can significantly affect your profitability and tax bill. When your team falls behind on expense reporting, you won’t have a clear picture of how profitable your business is. You will see paid invoices from clients but not the total project costs.
Poor reporting can also cause you to pay higher taxes in the short term because you cannot deduct your operating expenses. Your profits are recorded, but not your costs.
Recording expenses in your books and including them in your taxes is easy. Tracking capitalized costs is harder. You will need to track a cost over time and factor in depreciation. Fortunately, many bookkeeping tools can account for asset depreciation rates.
Decision Factors in Capitalizing vs Expensing
Develop criteria in your business to determine whether a purchase will be considered an expense or capitalized asset. Here are a few questions to ask:
- Will this cost be used for a single client or multiple customers?
- How long will the company be able to use the product or service?
- What is the cost of the purchase? Does it meet the capitalization threshold?
The project scale and duration will also determine whether a cost is an asset or something to be expensed. For example, you might need a piece of equipment for a project that lasts a year. That doesn’t necessarily mean it is an asset unless you plan to use it for other projects in the future.
The Role of AI-Powered Estimation Software in Managing Project Costs
Understanding capitalized assets and expenses can help you better budget your projects to ensure accuracy. These are just one tool that you have in your bookkeeping bag. Other tools include accurate takeoff software that uses AI-powered cost estimators to plan your projects. Dedicated software tools for contractors can help you create useful and transparent estimates that benefit all parties.
As you explore estimation software, make sure you choose features that meet your needs. Here are a few tools that can improve your cost management and help you decide whether a cost should be capitalized:
- Digital cost estimators that speed up the expense tracking process.
- AI-powered tools that use machine learning to improve cost estimates.
- Construction-centric systems that account for MEP (Mechanical, Electrical, and Plumbing) projects.
- Flexible tools that allow for multiple types of estimating.
These features will allow you to scale your business and account for unique budgeting and estimating requirements that come with different projects.
Enhancing Balance Sheet Accuracy with AI
AI can significantly help with financial reporting. These tools can automatically record and sort costs into different categories on your balance sheet, making it easier for you to manage them.
Good bookkeeping is essential for any business, but particularly for construction companies that deal with complex projects involving both materials and labor. Get the right tools to help.
Best Practices for Accurate Financial Reporting in Construction
As you start tracking capitalized costs and differentiating them from expenses, you may need to adopt some accounting best practices to keep your systems organized. Here are a few tips to better maintain your records:
- Report expenses as soon as you accrue them. This can prevent backlogs.
- Regularly audit your financial statements for accuracy and make corrections as needed. Monthly checks can keep everything in order.
- Train anyone who reports expenses on how to do this accurately. Retrain as needed.
- Work with an objective bookkeeper or auditor to manage your finances. Tap into their expertise.
Capitalizing costs can help you better manage your finances and track the value of your assets. Knowing how to do this can improve your operations and help you set fair pricing for your customers.
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