Capitalizing is an accounting method used to recognize 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 a company decides 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.

BREAKING DOWN Capitalize

Capitalizing and expensing are crucial accounting terms to know. In brief, it refers to how a cost is treated on the entity’s financial statements. This means businesses have two options when adding a cost to their income statement. They can either expense it or capitalise it.

There have been some instances where companies have used capitalizing of regular operating expenses against common accounting procedures, most likely to artificially boost its operating cash flow. While this might influence the short-term profits of the company, these illegal practices are generally exposed in the long run. It is critical to separate the concepts of capitalizing and market capitalization.

Companies can typically capitalise costs only when the resource acquired will provide future value. This means resources that are beneficial for the business for more than one operating cycle.

Therefore, the expenses from acquiring these resources are recorded by accountants as assets in the company’s balance sheet. The costs will then show on the balance sheet in the coming financial years through amortization or depreciation.

Companies should also consider capitalizing costs when they add significantly to the value of an existing resource. If the company upgrades part of the tools, property or equipment it uses, in a manner that directly increases the value of the asset, it could be capitalized.

Capitalization Example

Let’s look at an example when a company purchased office furniture to use it in a building. It was a large purchase and the total cost of furniture was $84,000. Upon receipt of the furniture at the building, the company paid the invoice, and the accountant entered the $84,000 expense into an asset account called Work in Process (WIP). This account accumulates all expenses that are intended to be long-term assets, but they have not yet been put into use, and therefore cannot yet be capitalized.

After installation of the furniture, the office is ready to go. The assets have been put into use, and the accountant can capitalize the $84,000 cost of furniture into long-term assets on the company’s balance sheet. The estimated useful life of the furniture, as defined by the company policy, and IRS tax code, is 7 years. So the company should recognize $1,000 per month, or ($84,000 cost ÷ 7 years) ÷ 12 months. This straight line calculation of the capitalized cost will ensure the company recognizes an appropriate amount of depreciation expense each year, no matter what month the furniture was put into use.

Companies prefer to capitalize assets because it reduces expenses and increases net income even though cash flow goes down. At the same time, it is not common for companies to expense office supplies and capitalize computers and cars.

Depreciation

Buildings, machinery, equipment, furniture, fixtures, computers, outdoor lighting, parking lots, cars, and trucks are examples of assets that will last for more than one year, but will not last indefinitely. The process of writing off or capitalizing such assets over the useful life is referred to as depreciation, or amortization for intangible assets. During each accounting period (year, quarter, month, etc.) a portion of the cost of these assets is being used up until the full value of the asset is written off of the balance sheet. In effect depreciation is the transfer of a portion of the asset's cost from the balance sheet to the income statement during each year of the asset's life. The annual depreciation expense comes out of net income and is determined based on the useful life of the asset, the total cost of the asset and the salvage value of the asset.