What is to Capitalize?

Capitalizing an asset is like putting an expense on a credit card…

If you make a $1,000 purchase with your debit card, the entire amount leaves your bank account right away, and you have to account for it in your budget. But let’s say that instead you purchase with a credit card. You can pay off a portion of the purchase every month, and your budget only reflects the monthly payments instead of the full $1,000. Similarly, capitalizing an expense allows a company to account for only a percentage of the cost each reporting period instead of recording the entire amount at once.

Sometimes companies purchase an item that will bring in revenue for years to come. These purchases, also known as capital expenditures (CapEx), include things such as equipment, land, and buildings. Because of the size and earning potential of these items, companies account for them differently than they do ordinary expenses.

When it comes to these large purchases that will bring a future economic benefit, companies capitalize them. When a company capitalizes a cost, it means it records the item that it purchased as an asset on its balance sheet. Then the company depreciates the asset over a specific number of years on its income statements.

The purchases that companies capitalize are often referred to as PP&E — Property, plant, and equipment. This classification refers to the land, buildings, and machinery that companies purchase. Other costs that a company might capitalize would be significant repairs or improvements to the property, plant, and equipment.

There are two sets of accounting standards that companies refer to when setting their capitalization policies. The generally accepted accounting principles (GAAP) apply to companies in the United States that have to release public financial statements. The GAAP doesn’t include a firm rule for capitalizing costs, but generally says that companies capitalize costs when they provide a future economic benefit for the company.

The other guidelines a company might follow are the International Financial Reporting Standards (IFRS), which are set forth by the International Accounting Standards Board. The IFRS is the set of accounting guidelines that many countries around the world use, though they do not apply in the United States for domestic companies.

Under the IFRS, companies should record something as an asset if it meets a couple of requirements. First, the asset must have a likely future economic benefit for the company. Additionally, the company must be able to measure the cost of the asset reliably.

Most companies set an internal capitalization limit, which is the cost at which they’ll treat a purchase as an asset rather than an expense. Neither set of accounting standards sets a specific capitalization limit that companies must follow.

Capitalization and depreciation are two accounting practices that go hand in hand. Think of depreciation as the second step of the capitalization process.

When a company capitalizes a cost, it records it as an asset on the balance sheet rather than as an expense on the income statement. But the asset still came at a cost to the company, and it has to account for that somehow. That’s where depreciation comes in — Depreciation is a reduction in value of the item for accounting purposes.

When a company depreciates an asset, it reports the asset’s costs as expenses over a period relatively equal to the number of years that the company will earn revenue from the asset (aka its useful life).

The number of years over which a company will depreciate an asset depends on that asset’s useful life. The Internal Revenue Service (IRS) offers some guidance as to the useful life of various purchases. For example, suppose that a company purchases servers for IT worth more than $50,000. The IRS’s recommended useful life of this purchase is seven years.

First, the company will report the value of the servers as a capitalized asset on its balance sheet for the current period. Then the company will depreciate the servers by one seventh every year for the next seven years. So, if they purchased $70,000 of servers, the company would depreciate the asset by $10,000 per year over seven years.

It’s important to remember that depreciation for tax purposes is not the same as a depreciation expense for accounting purposes. However, the IRS’s useful life table can still provide a helpful guideline for companies depreciating assets on their income statements.

A capitalized cost is one that the company records as an asset on the balance sheet and depreciates over several years. Expenses, on the other hand, are those costs that a company incurs throughout the year and records on the income statement. Expenses, along with revenue, are what the company uses to determine its profit for the year.

Most often, companies use capitalizing and expensing for two different types of purchases. For large purchases that the company will use to earn revenue for years to come, they’ll likely capitalize them. For smaller purchases and operating expenses (meaning regular day-to-day expenses), the company is likely to expense them on the income statement.

Suppose that a company purchases a new building out of which to run its business. The building is an asset that will bring future financial benefits, so the company would capitalize that cost. But the money the company pays to have electricity and water in the building is an operating expense. Therefore, they would record those as expenses on the income statement.

Most companies will have a policy and capitalization limit in place to help them determine which costs to capitalize versus expense. They’ll use those policies along with the generally accepted accounting principles (GAAP) to decide how to account for each purchase.

The ability to capitalize costs rather than reporting them as an expense can be very beneficial for companies. First, capitalization allows companies to increase the value of their assets on the balance sheet. If they purchase a valuable piece of equipment, it appears under its lists of assets.

Capitalization also allows a company’s financial statements to report better profit margins in the year they make a large purchase. Suppose a company buys a piece of equipment worth $150,000, and its income for that year is $500,000. The price of the equipment would take a significant chunk out of the company’s profit margins for the year if it were to expense it on its income statement. But by capitalizing it, the financial statements can better reflect the fact that the return on investment for that purchase will come over several years.

That being said, there are also benefits to expensing an item instead of capitalizing. The deduction a company could get for an expense in the current year may be more valuable to them than the financial benefits of capitalizing.

Capitalization is a way for companies to report purchases that reflects the long-term financial benefits of the asset. That being said, there are some limitations.

There are some things that companies might spend a lot of money on, and that will bring future economic benefits, but that they can’t capitalize. Under the generally accepted accounting principles (GAAP), costs related to research and development (R&D) cannot be capitalized. Instead, companies must expense those costs in the year that they occurred.

Suppose that you’re a U.S.-based company working on the R&D of a new software product. You spend about $100,000 in a single year on R&D. You expect the product to be a huge success and bring in revenue for the company for years to come. Over the subsequent five years, the software product results in $5M in revenue. Regardless of the future economic benefit of the software product, you must report the entire $100,000 on your income statement as an expense.

The rules for capitalization also differ between the United States and much of the rest of the world. For companies who have to comply with the International Financial Reporting Standards (IFRS), they must expense costs related to research but may be able to capitalize costs associated with development.

Suppose that your company was undertaking R&D for that software product. Rather than reporting the entire $100,000 as an expense, you would divide up the costs between research and development. You would record the research costs as an expense on your income statement and could capitalize the development costs as an asset on your balance sheet.

Market capitalization is another form of the term “capitalization” that companies use; it is generally unrelated to the capitalization of assets. A company’s market capitalization refers to the value of all of a company’s stock. You can find a company’s market capitalization by multiplying the stock’s price per share by the total number of shares outstanding.

Market capitalization is a concept that is relevant to investors. They might look at a company’s market capitalization to determine the size of a company compared to others. Firms are usually considered either large-cap, mid-cap, or small-cap companies, depending on their market capitalization.