Capitalize: Meaning & Definition
A businesses balance sheet contains a wide array of vital information for the day to day running of the company.
An important part of running a business is recording your costs or expenses and it is by doing this task that the term capitalize will often crop up.
But what exactly is capitalization? And why is it so important?
Read on as we take a look at everything you’ll need to know about this term, as well as the benefits, the limitations, and answer some of your frequently asked questions.
Table of Contents
KEY TAKEAWAYS
- Capitalization is when you include expenses on your balance sheet.
- Capitalizing expenses helps improve your cash flow management and increases profitability.
- Capitalization works on PP&E, advertising expenses, and intangible assets.
What Is Capitalize?
Capitalize refers to the act of recording cost or expenses on a balance sheet. This is to spread the cost over the life of an asset, rather than expensing it all at once. By capitalizing an expense and spreading the cost over its useful life, it is correlating profit generated by this asset with the portion of expense used to create that profit in each of the years when it’s in use. A balance sheet reports shareholders’ equity in a company, as well as liabilities and assets in a specific period.
The main purpose of a balance sheet is to give stakeholders a clue of the company’s financial health. The balance sheet can also be used to assess whether a company has the resources to pay its debts when they come due.
The balance sheet is one of three important financial statements. Along with the income statement and cash flow statement. Together, these three statements give investors a clear picture of a company’s financial position.
The balance sheet has two sections: the asset side and the liability side. The asset side lists all of the resources that a company owns, while the liability side lists all of the claims against those assets.
There are several list of characters that you can capitalize on a balance sheet, such as:
- Property, plant, and equipment (PP&E)
- Intangible assets
- Research and development costs
The decision of whether or not to capitalize an expense is often made by accounting departments on a case-by-case basis. There are generally two schools of thought when it comes to capitalization:
- Capitalize all expenses above an internally determined threshold that will generate future revenue.
- Only capitalize expenses that have a long-term benefit.
The first approach is more aggressive and impacts the income statement as it reduces the expenses in the year of all the purchases and increases depreciation expenses in the following years. The second approach is more conservative and may result in a more reasonable presentation of expenses on the income statement. Ultimately, the decision of how to treat an expense should consider the company’s overall financial strategy.
Benefits of Capitalization
There are several benefits you can achieve by capitalizing expenses on a balance sheet. These benefits include:
- Improved income statement presentation: By capitalizing an expense, a company can better present its profit and loss by spreading the cost over the time the asset is used to generate profit. This allows the company to avoid showing uneven income statements from year to year and having difficulty in comparing financial performances properly.
- More informed decision-making: Capitalization provides a company with more information about its expenses. And how they impact its financial position. This information can make more informed decisions about where to allocate resources.
- Tax advantages: Capitalizing an expense may result in tax advantages or disadvantages. This is because the expense reduces taxable income and is a matter of paying less tax in the year of purchase but more in later years (if not capitalized) or paying taxes evenly across the year.
- Increased profitability: Capitalizing expenses can often lead to increased profitability. This is because the expense spreads out over time, rather than expensed all at once. Sometimes management might choose to capitalize more expenses if their performances are measured based on profitability.
Limitations of Capitalization
There is a potential drawback to capitalizing expenses on a balance sheet – complexity. More capitalized assets means more work required by accounting staff to calculate and record depreciation expenses each period and each year, and that process can be complex. This complexity can make small businesses hesitate to properly capitalize their expenses.
What Type of Assets are Capitalized?
There are several types of assets you can capitalize on a balance sheet. These assets include:
- Property, plant, and equipment (PP&E): PP&E are long-term assets that are in the operation of a business. They include buildings, machinery, vehicles, and other equipment.
- Intangible assets: Intangible assets are non-physical assets that have a value to the company. They include patents, copyrights, and trademarks.
- Research and development costs: R&D costs are expenses incurred by a company in the process of developing new products or services.
- Advertising expenses: These expenses are costs incurred by a company to promote its products or services.
- Pre-production costs: These are expenses incurred by a company in the process of setting up production for a new product or service.
Summary
Capitalization is the process of including an expense on a balance sheet. Better presented profit and loss and increased profitability in the year of purchase are some of the benefits of capitalization.
You can capitalize several types of assets, including PP&E, intangible assets, and advertising expenses. Be sure to weigh the pros and cons of capitalization before making any decisions.
Capital Market Line FAQs
An example of something that would be capitalized would be if a company bought a new factory. The cost of the factory would get capitalized because it is an asset that would bring long-term benefits.
No, capitalize is not the same as depreciation. Depreciation is an accounting method used to allocate the cost of a long-term asset over its useful life. Capitalize refers to the act of recording an expense on a balance sheet as an asset. Only when an asset has been capitalized, the depreciation will then start when the asset is put into use.
Capitalized refers to an expense recorded as an asset. Amortized refers to a process that allocates cost of assets over life. Amortization is a type of depreciation.
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