What is Capitalize in Accounting?
Capitalization is recognizing the expense of a long-term asset over a specified period of time, which is typically defined by the useful life of the long-term asset. When an entity elects to capitalize an expense, it’s reducing the amount of expense associated with the asset in a given period by spreading recognition of the expense over the useful life of the asset.
An item is capitalized when it is recorded as an asset, rather than an expense. This means that the expenditure will appear in the balance sheet, rather than the income statement. You would normally capitalize an expenditure when it meets both of the following criteria:
Asset Exceeds Capitalization Limit
Companies set a capitalization limit, below which expenditures are deemed too immaterial to capitalize, as well as to maintain in the accounting records for a long period of time. A common capitalization limit is $1,000. The materiality principle applies to the capitalization concept.
Asset Has a Useful Life of at Least One Year
If an expenditure is expected to help the company generate revenues for a long period of time, then you should record it as an asset and then depreciate it over its useful life, which agrees with the matching principle.
What Does Capitalize Mean?
Typically speaking, entities maintain a capitalization policy, and they capitalize large investments that are recognized as an asset on the balance sheet. These assets provide benefit to the business over a specific useful life, and therefore the entity can spread the recognition of the cost (expense) of the asset over that time period. There are many benefits to capitalization, but the most significant benefit is the expense reduction in a given period of time. As it relates to the capitalization of assets, such as a building, the expense is recognized as depreciation expense each period.
What does it mean to capitalize an expense? While a variety of policies or rules may define the useful life of a long-term asset owned by an entity, the useful life is considered to be an estimate. Entities use the estimated useful life of an asset to defer the purchase cost of the asset over the estimated useful life. Typically, a straight-line methodology is applied to the calculation, which means the organization equally spreads recognition of the expense over the useful life of the capitalized asset.
Alternatives to Capitalization
When an asset has a useful life of just a few months, it may be more efficient to simply record it as a prepaid expense (a short-term asset), and then charge it to expense at a steady pace over its life.
Examples of Capitalization
Here are several examples to illustrate the concept:
A company pays $500 for a notebook computer. The computer has a useful life of three years, but it does not meet the company’s $1,000 capitalization limit, so the controller charges it to expense in the current period.
A company pays $2,000 for maintenance on a machine. The payment exceeds the company’s capitalization limit, but it has no useful life, so the controller charges it to expense in the current period.
A company pays $3,000 for a router. The router has a useful life of four years and surpasses the corporate capitalization limit of $1,000, so the controller records it as a fixed asset and begins depreciating it over its useful life.
Benefits of Capitalization
Capitalizing assets has many benefits. Because long-term assets are costly, expensing the cost over future periods reduces significant fluctuations in income, especially for small firms. Many lenders require companies to maintain a specific debt-to-equity ratio. If large long-term assets were expensed immediately, it could compromise the required ratio for existing loans or could prevent firms from receiving new loans.
Also, capitalizing expenses increases a company’s asset balance without affecting its liability balance. As a result, many financial ratios will appear favorable. Despite this benefit, it should not be the motivation for capitalizing an expense.