CFA Level I Exam · Analysis of Long-Term Assets

Capitalizing vs Expensing Costs for CFA Level I

Updated 7 October 2026 · Fact-checked

Capitalizing means recording a cost as an asset on the balance sheet and spreading it through depreciation. Expensing means charging it to the income statement now. Capitalize costs that give future benefits, such as purchase price and borrowing costs on qualifying assets. Expense costs that do not, such as most research costs.

Understand Capitalizing vs Expensing Costs

Every cost a company pays either gives benefits beyond this period or it does not. If it does, the cost is capitalized: it goes on the balance sheet as an asset and is expensed later through depreciation or amortization. If it does not, the cost is expensed and reduces profit immediately.

Under both IFRS and US GAAP, the cost of a purchased long-term asset includes the price plus all costs needed to get it ready for use: freight, installation, testing and non-refundable taxes. Costs after the asset is in use are capitalized only if they extend its life or raise its output. Routine repairs are expensed.

Internally generated intangibles are where the two frameworks differ. Under IFRS, research costs are expensed, but development costs are capitalized once criteria are met (technical feasibility, intention and ability to complete and use or sell, probable future benefits, and reliable measurement of cost). Under US GAAP, both research and development costs are generally expensed (software development has separate rules). So an IFRS company can show higher assets and profit than an otherwise identical US GAAP company.

Borrowing costs (interest) on debt used to build a qualifying asset are capitalized during construction. A qualifying asset takes a substantial period to get ready, such as a plant or ship. Under IFRS, interest income earned on temporarily invested borrowed funds is deducted from the interest capitalized. Under US GAAP, that interest income is generally not offset. Capitalized interest is later expensed as part of depreciation.

Effect on statements: capitalizing gives higher assets, equity, and early profit and operating cash flow. Cash paid moves to investing cash flow. Expensing gives lower early profit and equity but higher profit later. Capitalized interest is generally included in investing outflows under US GAAP. Under IFRS, interest paid (including capitalized interest) may be shown in operating, investing or financing, depending on the entity's policy. Expensed interest is operating under US GAAP, and operating or financing at the entity's choice under IFRS. Capitalizing typically raises early ROA, margins and reported interest coverage, but the ROA effect depends on the relative change in income and assets, since both rise. Total cost over the life is the same.

Reported interest coverage is overstated when interest is capitalized, because the capitalized part is left out of interest expense. When you compute coverage ratios, include capitalized interest in interest expense (use total interest incurred) to get a fair measure.

Key formulas to remember

Capitalized interest (weighted-average, avoidable interest approach): Interest capitalized = Weighted average accumulated expenditures × Interest rate (limited to actual interest incurred); Used mainly under US GAAP and for general borrowings. Weight each expenditure by the fraction of the year it was outstanding. For a specific loan, use the actual interest incurred on that loan (see the next formula).
IFRS net borrowing cost on specific loans: Capitalized borrowing cost = Interest incurred on the specific loan − Investment income on temporary investment of the funds; US GAAP generally does not subtract the investment income.
Capitalized cost of purchased asset: Cost = Purchase price + Costs to bring the asset to location and condition for use; Excludes training, admin overhead and abnormal waste.
Profit effect of capitalizing: Capitalize: expense now = 0, then depreciation over life. Expense: full cost in current-year expense; Total expense over the life is equal; only timing differs.
Cash flow classification: Capitalized cost → investing outflow; expensed cost → operating outflow; Capitalizing raises CFO.

How to solve Capitalizing vs Expensing Costs questions

Use this order for any question on capitalizing versus expensing.

1Identify the cost type: purchase, subsequent spending, research, development, software or interest.
2Ask whether it creates future economic benefit and is needed to ready the asset for use.
3Apply the framework: IFRS or US GAAP. Check the question for which applies.
4For interest, confirm the asset is a qualifying asset and the period is construction only.
5Compute: weight expenditures by time, apply the rate, cap at actual interest, and under IFRS deduct investment income on specific borrowings.
6Trace the effect on assets, net income, equity, CFO, CFI and ratios in the early years.
7Pick the option that matches direction and size, and eliminate the other two.

Quickest way: Direction-of-effect shortcut

When to use it: Use when the question asks how a choice changes ratios or statements and no heavy calculation is needed.

Capitalizing means higher assets, higher early net income, higher equity and higher CFO.
Capitalizing means lower CFI (bigger outflow) and higher early margins and coverage ratios. Early ROA is typically higher too, but it depends on the relative change in income and assets.
Debt-to-equity may move either way, so compute it if asked.
Later years reverse: higher depreciation and lower income than expensing.
For IFRS vs US GAAP development costs, IFRS can capitalize and US GAAP generally expenses.

Common mistakes in Capitalizing vs Expensing Costs

Capitalizing research costs under IFRS
Students assume R&D is treated as one item.
Fix: Research is expensed; only development meeting the criteria is capitalized.
Capitalizing interest for the full year regardless of timing
Forgetting to weight expenditures.
Fix: Multiply each expenditure by months outstanding ÷ 12 before applying the rate.
Ignoring the cap at actual interest incurred
Focus is on the formula result only.
Fix: Capitalized interest cannot exceed interest actually incurred in the period.
Forgetting IFRS deducts investment income on specific borrowings
Mixing up IFRS and US GAAP.
Fix: IFRS nets it off; US GAAP generally does not.
Saying capitalizing increases total lifetime profit
Early years look better.
Fix: Total expense is equal over the life. Capitalizing only defers expense.
Putting capitalized costs in operating cash flow
Cash left the firm, so it feels operating.
Fix: Capitalized costs are investing outflows, which is why CFO rises.

Worked examples

Example 1

A company builds a plant under IFRS. It borrowed a specific loan of EUR 10 million at 6% for the full year. Of this, EUR 2 million was invested temporarily for the year and earned 2%. All interest relates to the plant. How much borrowing cost is capitalized? A) EUR 0.56 million B) EUR 0.60 million C) EUR 0.64 million

Show the solution

Interest incurred = 10,000,000 × 6% = EUR 600,000.
Investment income = 2,000,000 × 2% = EUR 40,000.
IFRS: capitalized = 600,000 − 40,000 = EUR 560,000.

Answer: A) EUR 0.56 million. Under US GAAP the investment income would generally not be deducted, giving EUR 0.60 million.

Example 2

In year 1 a firm pays USD 500,000 in cash on development of a new product that meets all IFRS capitalization criteria. Assume amortization of the capitalized cost starts in year 2, so there is no amortization in year 1, and ignore tax. Compared with expensing the cost (US GAAP), what is the effect on year 1 pre-tax income and CFO under IFRS? A) Income higher by USD 400,000; CFO higher by USD 400,000 B) Income higher by USD 500,000; CFO unchanged C) Income higher by USD 500,000; CFO higher by USD 500,000

Show the solution

Under IFRS the USD 500,000 is capitalized. Year 1 expense is 0 because amortization starts in year 2.
Under expensing, year 1 expense is USD 500,000, so IFRS pre-tax income is USD 500,000 higher. (Option A would apply only if USD 100,000 were amortized in year 1.)
Total cash paid is USD 500,000 in both cases. Under IFRS it is an investing outflow. Under expensing it is an operating outflow.
So CFO is USD 500,000 higher under IFRS, not unchanged. CFI is USD 500,000 lower.

Answer: C) Income and CFO are both higher by USD 500,000 in year 1. CFO is higher because the spending moves to investing, and total cash is unchanged.

Exam tips

Always check whether the question says IFRS or US GAAP before choosing the treatment.
For interest, write the three numbers: weighted expenditure, rate result, actual interest cap.
Memorize the direction table: capitalizing raises assets, equity, early income and CFO, and lowers CFI. Early ROA is typically higher, but compute it if the question depends on it.
With three options, eliminate those that contradict direction first, then compute only if two remain.

Practice questions from Analysis of Long-Term Assets

Capitalizing vs Expensing Costs: frequently asked questions

What is the difference between capitalizing and expensing a cost?

Capitalizing records the cost as an asset and charges it to income over time through depreciation or amortization. Expensing charges the full cost to the income statement immediately. Total expense over the asset's life is the same.

How does capitalizing interest affect financial ratios?

It increases assets and early net income and keeps interest out of expense, so reported interest coverage looks stronger. Cash paid is shown in investing, so CFO is higher. Analysts should add capitalized interest back to interest expense when computing coverage. Later, depreciation includes the capitalized interest.

How do IFRS and US GAAP differ on borrowing costs?

Both require capitalizing borrowing costs on qualifying assets. IFRS deducts investment income earned on temporarily invested specific borrowings, while US GAAP generally does not.

Are development costs capitalized under US GAAP?

Generally no. US GAAP expenses both research and development, with separate rules for some software costs. IFRS capitalizes development costs once the specified criteria are met.