Capitalizing vs Expensing: Why It Moves EBITDA

Introduction

In June 2002, the Securities and Exchange Commission (SEC) charged WorldCom with fraud for a scheme built on a single accounting choice. Over five quarters, the company had recorded about $3.8 billion of ordinary operating costs, fees it paid other carriers for network access, as capital expenditure (capex). The costs that should have reduced profit immediately sat on the balance sheet as assets, overstating pre-tax income by about $3.1 billion in 2001 and $0.8 billion in the first quarter of 2002, according to the SEC's litigation release. Its cash flow from operations looked stronger too, because the payments had moved into the investing section.

WorldCom's choice was fraudulent because the costs had no future benefit. But the same choice, made legitimately, runs through the accounts of almost every company. Equipment, buildings, software, sales commissions and the interest on construction loans are all capitalized under specific rules, and each capitalization moves profit, earnings before interest, taxes, depreciation and amortization (EBITDA) and cash flow classification in ways that matter for valuation. Understanding the mechanics, and where the line between asset and expense falls, is what lets a banker compare companies that make different choices.

A cost is capitalized, recorded as an asset, when it is expected to produce economic benefits beyond the current period. It then reaches the income statement gradually, as depreciation or amortization, over the periods that benefit. A cost that benefits only the current period is expensed immediately. That is the matching principle at work, explained in recognition and matching principles.

Capitalization

Recording a cost as an asset on the balance sheet, rather than as an expense on the income statement, because it is expected to provide economic benefits in future periods. The capitalized amount is then depreciated or amortized over those periods.

In practice, US generally accepted accounting principles (US GAAP) do not leave the judgment to a general principle. Specific topics of the Accounting Standards Codification (ASC) decide the main categories:

The categories leave room for judgment at the edges: whether a repair extends an asset's life or merely maintains it, when a software project becomes probable of completion, or how long a commission's benefit lasts. Those judgments are where comparability breaks down.

Repairs, Improvements and Capitalization Thresholds

The line between maintenance and improvement is the oldest capitalization judgment. Patching a leaking roof keeps a building in its existing condition, so it is expensed; replacing the roof with one that extends the building's life is an improvement, so it is capitalized and depreciated. Relining a blast furnace usually falls on the capitalization side, because it restores capacity for years, while routine servicing does not. Each company sets policies to apply the distinction consistently, and the useful lives it assigns to capitalized improvements, explained in useful lives and salvage values, decide how quickly the cost returns to the income statement.

Companies also set a capitalization threshold, a minimum amount below which purchases are expensed even if they will last several years, because tracking small items as assets costs more than it is worth. US tax rules offer a parallel de minimis safe harbor that lets businesses expense low-cost items, commonly up to $2,500 per item, or $5,000 for businesses with audited financial statements. A laptop bought by a large company is therefore often an expense, not an asset, which is immaterial for any single item but means that capital expenditure is never a complete measure of spending on long-lived assets.

Capitalized Interest

When a company borrows to build a long-lived asset, such as a factory, a data center or a ship, ASC 835-20 requires the interest incurred during construction to be added to the asset's cost rather than expensed. The amount is based on the average accumulated spending on the project and the company's borrowing rate. Suppose a company spends an average of $500 on a plant under construction during a year in which its borrowing rate is 6%: $30 of interest is capitalized, reducing interest expense by $30 and raising the plant's cost by the same amount, to be depreciated once it is in service. On the cash flow statement, the interest paid that has been capitalized is classified with capital expenditure in investing activities. Companies in heavy building programs can therefore report interest expense well below the interest they actually pay, a point covered in interest and other non-operating items.

Capitalized interest

Interest incurred on borrowing during the construction of a qualifying long-lived asset that is added to the asset's cost instead of being expensed. It reduces interest expense while construction lasts and is recognized later through depreciation of the completed asset.

Software Under the New Rules

Internal-use software is the category where the rules are changing. Until now, ASC 350-40 has required companies to capitalize costs incurred in the application development stage of a project and expense those in the preliminary and post-implementation stages. Accounting Standards Update (ASU) 2025-06, issued in September 2025, removes the stages and replaces them with a principles-based test: capitalization begins when management has authorized and committed to funding the project and it is probable the project will be completed and the software used as intended, after any significant development uncertainty has been resolved. BDO's summary of the internal-use software update notes it is effective for annual periods beginning after December 15, 2027, with early adoption permitted. Companies developing software in agile cycles, where the old stages never fitted well, may find their capitalized amounts change when they adopt it.

Cloud software adds another twist. When a company pays to implement software it accesses as a hosted service rather than owns, ASU 2018-15 requires it to capitalize the implementation costs under the same internal-use software rules, but to amortize them in the same income statement line as the hosting fees and to present the cash paid in operating activities. Unlike capitalized software the company owns, which is amortized below EBITDA and paid for in investing activities, these costs reduce EBITDA as they are amortized. Two companies spending the same amount on the same enterprise system can therefore show different EBITDA depending on whether they license it or subscribe to it.

The effect of the choice is easiest to see on a single cost. Suppose a company spends $100 in cash on something that could plausibly be capitalized and amortized over five years, or expensed at once. Assume a 25% tax rate and that the cost is deductible for tax immediately in both cases, so total cash is the same:

Total cash and free cash flow are identical, because the same $100 left the company and the same tax was saved. Everything else differs. Capitalizing keeps EBITDA unchanged, reduces earnings before interest and taxes (EBIT) by only the $20 of amortization and net income by $15 instead of $75, and moves the cash outflow from operating to investing activities, so operating cash flow is $100 higher. Over five years the income statement totals converge, since the whole $100 is eventually amortized, but EBITDA never does: the capitalized cost bypasses EBITDA forever. The year-by-year effect on profit shows the timing:

The amortization pattern is the same mechanism traced for any non-cash charge in depreciation on the three statements.

The Steady State: EBIT Converges, EBITDA Never Does

The single-cost example understates the long-run effect. Suppose a company spends $100 a year, every year, on costs it capitalizes and amortizes over five years. In year one, amortization is $20; in year two, $40; by year five, five years of spending are being amortized at $20 each, so amortization reaches $100 and stays there. From then on, the capitalizer's EBIT and net income are identical to those of a company that expenses the same $100 each year. Its EBITDA, however, remains $100 higher in every year, permanently, because amortization is excluded from EBITDA while the expenser's cost is not. A growing company, whose spending rises each year, sees the gap in EBIT persist too, since amortization always lags current spending. For mature companies, the capitalization choice therefore matters little for earnings but a great deal for EBITDA, and for any valuation built on it.

That last point is why the choice matters so much for valuation. A company that capitalizes more of its spending reports higher EBITDA and higher operating cash flow than an otherwise identical company that expenses it, and EBITDA multiples will make it look cheaper. How EBITDA is built, and what it leaves out, is covered in operating income, EBIT and EBITDA.

Real filings show the choices at scale. Salesforce capitalizes the sales commissions and related costs of winning customer contracts under ASC 340-40. It amortizes those for new contracts over four years, longer than its typical initial contract, to reflect expected renewals, and those for renewals over two years. Its fiscal 2026 annual report shows the effect on both statements:

In fiscal 2026, Salesforce capitalized $2.8 billion of contract costs and amortized $2.2 billion of earlier ones. Had it expensed all of them as incurred, operating income would have been about $614 million, or 7%, lower. Unlike capitalized equipment, these costs stay in operating cash flow on both sides, as an outflow when paid and an add-back as amortized, so operating cash flow is unaffected; only the income statement timing changes. When commission spending grows quickly, capitalization raises reported margins relative to expensing; when it levels off, the two converge.

Software and equipment take a different route. Macy's reported $367 million of capitalized software in investing activities in fiscal 2025, almost as much as its $373 million of property and equipment purchases, according to its fiscal 2025 annual report. That spending never passes through operating cash flow, and its amortization, $351 million that year, is excluded from EBITDA along with depreciation, so the software sits outside EBITDA entirely. Interest on loans used to build long-lived assets is capitalized into their cost, reducing interest expense while construction lasts, as described above. The investing lines where these amounts appear are explained in cash flow from investing activities.

Research and Development: Expensed by Default

US GAAP takes the opposite approach for research and development (R&D). With limited exceptions, mainly software, R&D is expensed as incurred, however valuable the resulting products may be. A pharmaceutical company that spends billions on a successful drug carries none of that spending on its balance sheet, while one that buys a drug through an acquisition records it as an intangible asset. The reasons for the rule, and its consequences for comparing companies, are covered in R&D accounting under US GAAP.

When Capitalized Projects Fail

Capitalization also changes how failure shows up. If a company abandons a software project or a development program it has been capitalizing, the accumulated costs are written off in a single impairment charge. A company that expensed the same costs as incurred would already have absorbed them in earlier years' operating expenses, with no charge at the end. The capitalizer's history therefore looks better in the good years and worse in the year of the write-off, and because impairments are usually presented as non-recurring and excluded from adjusted earnings, the cost of the failed spending can escape adjusted figures altogether. The statement effects of such write-downs are traced in impairments and write-downs on the three statements.

Capitalization policies are one of the first things bankers check when comparing companies or examining a target's earnings quality. The questions are practical:

A simple screen catches the pattern that reclassification leaves behind. If capital expenditure rises from 10% to 14% of revenue while revenue is flat and the company announces no new investment program, the extra 4% of revenue being capitalized has to be explained. If operating expenses fall by a similar amount at the same time, the two movements together are exactly what reclassifying operating costs as assets would produce, and the cost lines in the notes deserve close reading. Totals alone do not always reveal it: WorldCom's transfers were found only when its internal audit team, led by Cynthia Cooper, reviewed the individual capital accounts in May 2002, as the company's sworn statement to the SEC describes.

Capitalization in Deals and Lending

In acquisitions and leveraged finance, the capitalization question becomes a negotiation over EBITDA. A seller presenting adjusted EBITDA has every incentive to classify spending as capital; a buyer, or the lenders funding the purchase, will test whether capitalized software, capitalized development and capitalized commissions are really recurring operating costs. Because purchase prices and debt capacity are usually set as multiples of EBITDA, a $10 million reclassification at a ten times multiple moves the valuation by $100 million. Credit agreements often define the EBITDA used in covenants precisely for this reason, and models projecting free cash flow treat capitalized software as part of capital expenditure, so that the cash cost is captured even when EBITDA excludes it.

In due diligence, these checks are part of the work described in quality of earnings, where reclassifying capitalized costs as expenses is one of the most common adjustments to a target's reported EBITDA. The underlying point is simple: capitalization changes when a cost is recognized and where its cash appears, not how much cash the business spends. A banker who tracks both, the timing on the income statement and the location on the cash flow statement, can see through any policy to the economics underneath.