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What Is to Capitalize?
Capitalization is the process of recording a cost or expense on the balance sheet for the purpose of delaying its full recognition. This process helps corporations reduce the impact of long-term expenses. Capitalization is also used to improve a company’s financial ratios and time its cash flows, which attracts investors and gives the business a more positive financial outlook.
Companies might capitalize expenses such as machinery or other expensive equipment needed for operations.
Key Takeaways
- Capitalization involves recording an expense as an asset on the balance sheet, delaying its recognition as an immediate expense, which can stabilize income over time.
- This approach helps manage large purchases by spreading the cost across the asset’s useful life, preventing significant fluctuations in reported income.
- Depreciation and amortization are methods used to allocate the cost of tangible and intangible assets, respectively, impacting how they are recorded on financial statements.
- Market capitalization refers to a company’s valuation based on the current stock price and the number of shares outstanding, distinguishing between large, mid, and small-cap firms.
- Proper capitalization aligns with accounting principles like the matching principle, ensuring expenses are recorded in the period they occur, thereby reflecting accurate financial health.
Investopedia / Jake Shi
How Capitalization Works in Business
One of the most important principles of accounting is the matching principle. The matching principle states expenses should be recorded when they occur, no matter when payment is made. Recognizing expenses in the period incurred allows businesses to identify amounts spent to generate revenue. For assets that are immediately consumed, this process is simple and sensible.
However, large assets that provide a future economic benefit present a different opportunity. For example, a company purchases a delivery truck for daily operations. The truck is expected to provide value over a period of 12 years. Instead of expensing the entire cost of the truck when purchased, accounting rules allow companies to write off the cost of the asset over its useful life (12 years).
In other words, the asset is written off as it is used. Most companies have an asset threshold, in which assets valued over a certain amount are automatically treated as a capitalized asset.
Advantages of Capitalizing Expenses and Assets
Capitalizing assets has many benefits. Expensing long-term asset costs over future periods reduces income fluctuations, especially for small firms. Many lenders require companies to maintain a specific debt-to-equity ratio. Expensing large long-term assets immediately might affect required loan ratios or hinder getting 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 on an expense.
Depreciation Explained: Asset Value Reduction
The process of writing off an asset over its useful life is referred to as depreciation, which is used for fixed assets, such as equipment. Amortization is used for intangible assets, such as intellectual property. Depreciation deducts a certain value from the asset every year until the full value of the asset is written off the balance sheet.
Income Statement
Depreciation is an expense recorded on the income statement; it is not to be confused with “accumulated depreciation,” which is a balance sheet contra account. The income statement depreciation expense is the amount of depreciation expensed for the period indicated on the income statement.
The accumulated depreciation balance sheet contra account is the cumulative total of depreciation expense recorded on the income statements from the asset’s acquisition until the time indicated on the balance sheet.
Leased Equipment
For leased equipment, capitalization is the conversion of an operating lease to a capital lease by classifying the leased asset as a purchased asset, which is recorded on the balance sheet as part of the company’s assets. The assigned value of the asset is the lesser of its fair market value or the present value of lease payments. Also, the amount of principal owed is recorded as a liability on the balance sheet.
Important
There are strict regulatory guidelines and best practices for capitalizing assets and expenses.
Understanding Market Capitalization and Its Impact
Another aspect of capitalization refers to the company’s capital structure. Capitalization can refer to the book value of capital, which is the sum of a company’s long-term debt, stock, and retained earnings, which represents a cumulative savings of profit or net income.
The alternative to the book value is market value. The market value of capital depends on the price of the company’s stock. It’s calculated by multiplying the stock price by the number of equity shares in the market. If the total number of shares outstanding is 1 billion, and the stock is currently priced at $10, the market capitalization is $10 billion.
Companies with a high market capitalization are referred to as large caps; companies with medium market capitalization are referred to as mid-caps, while companies with small capitalization are referred to as small caps.
It is possible to be overcapitalized or undercapitalized. Overcapitalization occurs when earnings are not enough to cover the cost of capital, such as interest payments to bondholders, or dividend payments to shareholders. Dividends are cash payments made to shareholders by companies. Undercapitalization occurs when there’s no need for outside capital because profits are high and earnings were underestimated.
Differentiating Between Capitalized Costs and Expenses
When trying to discern what a capitalized cost is, it’s first important to make the distinction between what is defined as a cost and an expense in the world of accounting. A transaction’s cost is the money spent to acquire an asset.
A company buying a forklift would mark such a purchase as a cost. An expense is a monetary value leaving the company; this would include something like paying the electricity bill or rent on a building.
Fast Fact
The term “capital” for wealth originates from the Medieval Latin capitale, meaning stock or property.
Challenges and Limitations of Capitalizing Costs
To capitalize assets is an important piece of modern financial accounting and is necessary to run a business. However, financial statements can be manipulated—for example, when a cost is expensed instead of capitalized. This understates current income but inflates future periods when depreciation should occur.
What Is Capitalization in Accounting?
In accounting, typically a purchase is recorded in the time accounting period in which it was bought. However, some expenses, such as office equipment, may be usable for several accounting periods beyond the one in which the purchase was made. These fixed assets are recorded on the general ledger as the historical cost of the asset. As a result, these costs are considered to be capitalized, not expensed. A portion of the cost is then recorded during each quarter of the item’s usable life in a process called depreciation.
What Is Capitalization in Finance?
In finance, capitalization is the company’s capital structure. It is the book value cost of capital, or the total of a company’s long-term debt, stock, and retained earnings. A company that is said to be undercapitalized does not have the capital to finance all obligations. Overcapitalization occurs when outside capital is determined to be unnecessary as profits were high enough and earnings were underestimated.
What Kinds of Costs Can Be Capitalized?
Any costs that benefit future periods should be capitalized and expensed, so as to reflect the lifespan of the item or items being purchased. Costs that can be capitalized include development costs, construction costs, or the purchase of capital assets such as vehicles or equipment.
The Bottom Line
Capitalizing in business is an accounting method of recording an expense on the balance sheet to delay its full recognition. The process is used for the purchase of fixed assets that have a long usable life, such as equipment or vehicles. The method allows businesses to manage substantial fluctuations in income, comply with debt-to-equity ratios, and promote favorable financial ratios.
When capitalizing costs, companies benefit future periods; however, when they capitalize expenses, it becomes an immediate cash flow. Both methods reflect favorably on the business because financial ratios and cash flow improve. But, a word of caution—companies have used capitalization methods in the past to manipulate financial results, so it’s important for investors to understand a firm’s capital structure and what it is trying to achieve when using capitalization. Businesses should exercise caution when using the method and ensure they provide transparency when capitalizing costs and expenses.
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