Many people can be confused by the accounting distinction between expenses and assets. For example, they would like to record research and development as assets instead of expenses, because those expenses create intellectual property. However, standard accounting and taxation law are both strict on the distinction:
- Expenses are deductible against income, so they reduce taxable income, but expenses cannot be depreciated, ever.
- Assets are not deductible against income, but assets whose value declines over time (usually long-term assets) can be depreciated.
Some people are also confused by the specific definition of startup expenses, startup assets, and startup financing. They would prefer to have a broader, more generic definition that includes, say, expenses incurred during the first year, or the first few months, of the plan. Unfortunately, this would also lead to double counting of expenses and nonstandard financial statements. All the expenses incurred during the first year have to appear in the profit and loss statement of the first year, and all expenses incurred before that have to appear as startup expenses.
This treatment is the only way to correctly deal with the tax implications and the proper assigning of expenses to the time periods in which they belong. Tax authorities and accounting standards are clear on this.
What a company spends to acquire assets is not deductible against income. For example, money spent on inventory is not deductible as an expense at the point when you buy it. Only when the inventory is sold, and therefore becomes cost of goods sold or cost of sales, does it reduce income.
Why You Do Not Want to Capitalize Expenses
Sometimes people want to treat expenses as assets. Ironically, that is usually a bad idea, for several reasons:
- Money spent buying assets is not tax deductible. Money spent on expenses is deductible.
- Capitalizing expenses creates the danger of overstating assets.
- If you capitalize the expense, it appears on your books as an asset. Having useless assets on the accounting books is not a good thing.
Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry.
