Under Generally Accepted Accounting Principles, project costs are capitalized when they create a new asset, extend the useful life of an existing one, or materially improve its function; they are expensed when they simply keep an asset running or support the business as a whole. Deciding whether project costs should be capitalized vs. expensed comes down to that single distinction, applied cost by cost, with a handful of specialized rules for interest, software, leases, and retirement obligations layered on top. Get the classification wrong in either direction and the financial statements distort: over-capitalize and both assets and income are overstated; over-expense and both are understated.
The Three-Part Test That Decides Borderline Cases
For spending on an asset the company already owns, the IRS tangible property regulations give a workable framework. A cost must be capitalized if it produces any one of three results:
- Betterment: it fixes a pre-existing defect, adds a major component or physical enlargement, or materially increases capacity, productivity, efficiency, or output.
- Restoration: it replaces a major component or substantial structural part, or brings an asset that has deteriorated beyond functional use back to working condition.
- Adaptation: it converts the asset to a new or different use that was not its original purpose.
Spending that fails all three tests is a repair or maintenance expense and hits the income statement immediately.1Internal Revenue Service. Tangible Property Final Regulations Repainting a warehouse is maintenance. Adding a second floor to the same warehouse is a betterment. Replacing a worn roof with the same type of roof is usually maintenance; replacing it with a structurally upgraded roof that extends the building’s life crosses into restoration or betterment.
The Dollar Threshold That Overrides the Rule
Not every qualifying cost is worth capitalizing. The IRS de minimis safe harbor election lets you expense small asset purchases outright, even if they technically produce benefits beyond one year. Thresholds depend on whether the business has an applicable financial statement, such as SEC-filed or audited financials with a CPA report:
- With an applicable financial statement: up to $5,000 per invoice or item.
- Without an applicable financial statement: up to $2,500 per invoice or item.
Purchases below the threshold can be deducted in the current year. Anything above it follows normal capitalization rules.1Internal Revenue Service. Tangible Property Final Regulations The election does not cover inventory or land. Many companies set their internal capitalization policy at or near these IRS figures so the books track the tax treatment.
What Goes on the Balance Sheet
Direct Materials
Raw materials that physically become part of the finished asset are the clearest capitalizable cost. Lumber, concrete, steel, electrical components, specialized hardware — purchased for the project and incorporated into the final product, all of it goes to the balance sheet. The capitalized amount includes the purchase price plus freight and nonrefundable taxes required to get the materials to the site. That figure becomes the baseline for depreciation.
Direct Labor
Wages paid to employees who physically build or assemble the asset are capitalized, and the calculation goes beyond base pay. Mandatory payroll taxes, Social Security at 6.2% and Medicare at 1.45%, are included, along with benefits like health insurance and retirement contributions for those specific workers.2Social Security Administration. FICA and SECA Tax Rates Only labor directly traceable to the project qualifies. Time the same employee spends on general company duties stays on the income statement. Detailed timekeeping is essential; it is the primary evidence auditors will ask for when reviewing capitalized labor.3Internal Revenue Service. IRS Audits – Records We Might Request
Not every material dollar makes it into the asset. Under ASC 330-10-30-7, abnormal amounts of wasted materials, unusual freight, and costs from operating below normal capacity must be expensed in the period they occur. If a crew ruins $40,000 of materials in a preventable accident, that loss is a current-period charge. Normal, predictable spoilage stays capitalized. The rule prevents operational mistakes from being buried inside an asset’s book value.
Acquisition and Site Preparation
Buying property and getting it ready generates a cascade of capitalizable costs. The purchase price of land or equipment is the obvious starting point, but professional fees tied to the transaction also qualify: legal costs for title searches, closing fees, recording charges, land surveys, and building permits. All of these transactional costs are added to the asset’s basis.
Physical site preparation follows the same logic. Clearing vegetation, grading soil, and demolishing existing structures are one-time costs necessary to bring the land to a usable state. If a company pays $50,000 to tear down a derelict building so it can construct a new facility, that demolition cost is added to the land’s carrying value, not the new building’s, because the work permanently improves the land itself. Readying costs end once the site is prepared and primary construction begins.
Environmental remediation is trickier. Cleanup is generally expensed as incurred, but it can be capitalized when it extends the property’s useful life, increases its capacity, improves its safety or efficiency beyond original condition, or prevents future contamination from planned operations. Cleaning up contamination that already existed when the property was purchased usually fails these tests, because it restores the land to baseline rather than improving beyond it. The distinction is fact-intensive and auditors scrutinize it.
Indirect Project Costs
Some costs never physically become part of the asset but exist only because the project exists. Rent on a construction trailer, utilities consumed exclusively at the job site, and insurance specific to the project all qualify. The test is straightforward: would this cost disappear if the project were cancelled tomorrow? If yes, capitalize. If the cost would continue regardless, as with corporate headquarters rent, the CFO’s salary, or company-wide IT systems, it is general overhead and must be expensed.
Equipment depreciation is often overlooked. When a company uses its own cranes, bulldozers, or heavy machinery on a construction project, depreciation on that equipment during the construction period moves from the income statement into the new asset’s capitalized cost. Salaries for project managers assigned to a specific site, along with quality-control inspection costs, fall into this same category.
Interest During Construction
Borrowing to finance a major project creates interest that GAAP treats as part of the asset’s historical cost under ASC 835-20. Interest incurred while getting an asset ready for use is considered as much a cost of acquisition as materials and labor. Under FASB Statement No. 34, interest is capitalized when two conditions are met: the company has begun activities to prepare the asset for its intended use, and it has incurred expenditures on the project.4FASB. Summary of Statement No. 34 – Capitalization of Interest Cost
The capitalization window has firm boundaries. Interest stops being capitalized once the asset is substantially complete and ready for use, even if the company has not yet put it into operation. If construction is suspended for a significant period, interest during the idle time must be expensed; you cannot keep adding interest to an asset nobody is working on. For a $10 million project financed at 6%, capitalized interest can reach several hundred thousand dollars over a multi-year build, so start and stop dates matter. The amount is calculated by applying the interest rate to the average accumulated expenditures throughout the construction period.4FASB. Summary of Statement No. 34 – Capitalization of Interest Cost
Special Asset Types
Internal-Use Software
Software built for a company’s own use follows ASC 350-40. The FASB issued ASU 2025-06 to remove references to specific software development stages, making the guidance neutral to different methodologies including agile, where work does not move through neat sequential phases.5Financial Accounting Standards Board. FASB Issues Standard That Makes Targeted Improvements to Internal-Use Software Guidance The underlying principle is unchanged: costs are capitalized when the work contributes directly to creating the software, and expensed when it involves planning, evaluation, training, or ongoing maintenance.6Financial Accounting Standards Board. ASU 2025-06 Intangibles Goodwill and Other Internal-Use Software Subtopic 350-40
Costs that are always expensed regardless of methodology include evaluating vendors, defining system requirements, training employees on the finished software, and routine post-launch maintenance. Coding, configuration, hardware installation, third-party consultant fees, and internal developer payroll during active development are capitalized. Testing to confirm the software functions as designed is the last major activity where costs can still be capitalized. Once the product is operational, the window closes.
Leasehold Improvements
When a company builds out or modifies a leased space, installing walls, upgrading HVAC, adding specialized wiring, those costs are capitalized as leasehold improvements. The capitalized amount is amortized over the shorter of the improvement’s useful life or the remaining lease term. Spend $200,000 renovating a space with a 10-year useful life but only 6 years left on the lease, and amortization runs 6 years.
The shorter-of rule exists because the improvement reverts to the landlord when the lease ends. If the lease terminates early, any unamortized balance is expensed immediately. Renewal options can extend the amortization period, but only if renewal is reasonably certain at the time the improvement is placed in service.
Right-of-Use Assets Under ASC 842
Since ASC 842 took effect, the lease itself creates a capitalized asset. Any lease with a term longer than 12 months requires the lessee to recognize a right-of-use asset alongside a corresponding lease liability. The initial value of the right-of-use asset equals the lease liability (the present value of remaining lease payments) plus any prepaid rent and initial direct costs, minus lease incentives received.
The lease liability is measured by discounting future payments at the rate implicit in the lease or, if that rate is not readily determinable, the lessee’s incremental borrowing rate. Non-public business entities can elect to use a risk-free rate. Capitalization applies to both operating and finance leases, though the subsequent expense patterns differ. Short-term leases of 12 months or less can be excluded by policy election.
Asset Retirement Obligations
Some long-lived assets come with a legal obligation to dismantle, remove, or remediate them at end of life: decommissioning an oil platform, closing a mine, removing underground storage tanks. Under ASC 410-20, the estimated cost of that future obligation is capitalized on day one. When the fair value of the retirement liability is first recognized, the carrying amount of the related asset is increased by the same dollar amount. The asset retirement cost is then depreciated over the remaining useful life, while the liability accretes over time. If a reasonable estimate cannot be made when the obligation is first incurred, recognition is deferred until one becomes possible.
Research and Development: The Big Exception
R&D is where companies most often bump into a capitalization ceiling. Under ASC 730, most R&D costs must be expensed as incurred. Lab research, prototype development, clinical trials, and experimental testing all hit the income statement immediately, no matter how promising the project. The reasoning is that R&D outcomes are too uncertain to meet GAAP’s threshold for recognizing a future economic benefit.
Two exceptions exist. Materials, equipment, or facilities purchased for R&D that have an alternative future use outside the specific research project can be capitalized and depreciated normally. A lab instrument the company will continue using after an experiment ends qualifies; custom equipment built solely for one study does not. And software development costs can be capitalized once certain criteria are met, either under the internal-use rules above or, for software intended for sale, once technological feasibility is established under ASC 985-20.
Costs That Always Get Expensed
Knowing what stays off the balance sheet matters as much as knowing what goes on it. Several project-related costs must be expensed no matter how tightly they connect to the work:
- General and administrative overhead: executive salaries, corporate rent, accounting department costs, and company-wide insurance premiums support the entire business, not a specific asset.
- Training costs: teaching employees to use a new asset or software benefits the employees, not the asset.
- Start-up and pre-opening costs: expenses to open a new facility or launch a new line of business, including hiring, advertising, and dry runs, are expensed under ASC 720-15.
- Abnormal waste: material spoilage, unusual freight, and costs from operating well below normal capacity are current-period charges.
- Preliminary project planning: feasibility studies, vendor evaluations, and strategic planning for a project that has not yet been approved.
- Routine maintenance: costs that keep an asset in its existing condition without improving it fail the betterment, restoration, and adaptation tests.1Internal Revenue Service. Tangible Property Final Regulations
The common thread across everything on this list: none of these costs create or improve a long-lived asset. They support daily operations or relate to activities too uncertain, too general, or too routine to produce a measurable future benefit. When the classification is genuinely unclear, the conservative move under GAAP is to expense. Capitalizing a cost that should have been expensed overstates both assets and income, which is the error pattern auditors look for hardest.