What “to capitalize” means (short definition)
– To capitalize in accounting means recording a cost as an asset on the balance sheet instead of charging it immediately as an expense. The cost is then written off over future periods that benefit from the asset, typically via depreciation (for tangible assets) or amortization (for intangible assets).
– In finance, “capitalization” can also mean measuring a firm’s capital—either book capitalization (equity + long‑term debt + retained earnings) or market capitalization (share price × shares outstanding). Context determines which meaning applies.
Key concepts and definitions
– Matching principle: an accounting rule that says expenses should be recognized in the same period as the revenues they help generate.
– Depreciation: the systematic allocation of the cost of a tangible fixed asset (e.g., machinery) to expense over its useful life.
– Amortization: the allocation of the cost of an intangible asset (e.g., patent) over its useful life.
– Accumulated depreciation: a contra‑asset account on the balance sheet that shows the total depreciation taken to date on an asset.
– Capitalization threshold (capitalization policy): a dollar cutoff a company uses to decide which purchases become capitalized assets vs. immediate expenses.
– Market capitalization (market cap): the market value of a company’s outstanding equity (share price × number of shares).
Why companies capitalize costs (benefits)
– Smooths reported profits by spreading large costs over multiple periods instead of creating a single large hit to income.
– Keeps asset balances higher, which can improve certain financial ratios (e.g., equity to assets).
– Helps lenders and investors view earnings and balance sheet structure in a way that reflects long‑lived assets providing future benefit.
– May be required by accounting standards when costs meet defined criteria for asset recognition.
What kinds of costs can be capitalized
– Costs that create a resource expected to provide future economic benefit and whose cost can be measured reliably. Examples:
– Purchase price of fixed assets (vehicles, equipment, buildings).
– Costs to construct an asset (labor, materials, some borrowing costs).
– Certain development costs (under narrow rules for intangible assets).
– Routine operating costs (utilities, rent, most repairs) are typically expensed when incurred.
How capitalization affects financial statements (brief)
– Initial purchase: record an asset on the balance sheet (debit asset, credit cash or liability).
– Over time: recognize periodic depreciation or amortization expense on the income statement; reduce asset book value on the balance sheet via accumulated depreciation.
– For leases treated as capital leases (under older GAAP terminology) or finance leases (under current standards): record a right‑of‑use asset and a corresponding lease liability. The asset is measured at the lower of fair value or the present value of lease payments (subject to standard rules).
Risks and limitations
– Capitalizing costs can be misused to inflate current profit or asset balances if management capsize expenditures that should be expensed. This can distort comparability across firms and periods.
– There are strict accounting rules and guidance (GAAP/IFRS) that set criteria for capitalization; incorrect treatment can lead to restatements or regulatory scrutiny.
– Capitalized assets still create future expenses (depreciation) and may affect future cash flows (maintenance, disposal costs).
Practical checklist: deciding whether to capitalize a cost
1. Does the expenditure create or improve a resource that will provide future economic benefit beyond the current reporting period (usually > 12 months)?
2. Can the cost be measured reliably and directly attributable to creating the asset?
3. Does the company’s capitalization policy (threshold) require capitalization for amounts above this cost?
4. Does the expenditure meet the recognition criteria in the applicable accounting framework (GAAP or IFRS)?
5. Are there regulatory, tax, or loan covenant implications to capitalizing vs. expensing?
6. If leased, does the lease meet the criteria to be recorded as a finance/ capital lease under current lease accounting rules?
If you answer “yes” to 1–4 (and 6 for leases), capitalization is usually appropriate; otherwise expense.
Step‑by‑step: typical journal entries (simple example)
1. On purchase of a machine for cash:
– Debit Equipment (asset) $X; Credit Cash $X.
2. Each reporting period to recognize depreciation (straight‑line method):
– Debit Depreciation Expense $Y; Credit Accumulated Depreciation $Y.
3. When disposed: remove asset and accumulated depreciation, record any gain or loss.
Worked numeric example (straight‑line depreciation)
Situation: Company buys a delivery truck for $60,000. Estimated salvage (residual) value after 12 years is $6,000. Useful life = 12 years.
– Depreciable base = Cost − Salvage = $60,000 − $6,000 = $54,000.
– Annual straight‑line depreciation = Depreciable base ÷
Useful life = 12 years.
– Annual straight‑line depreciation = Depreciable base ÷ Useful life = $54,000 ÷ 12 = $4,500 per year.
Journal entries (numeric example)
1) At purchase (time 0)
– Debit Equipment (asset) $60,000
– Credit Cash $60,000
2) Each year to record depreciation (years 1–12)
– Debit Depreciation Expense $4,500
– Credit Accumulated Depreciation $4,500
3) Carrying (book) value after n years
– Accumulated depreciation after n years = $4,500 × n
– Carrying value = Cost − Accumulated depreciation
Example: after 3 years carrying value = $60,000 − ($4,500 × 3) = $46,500.
4) Example disposal (sell at end of year 5 for $40,000)
– Accumulated depreciation = $4,500 × 5 = $22,500
– Carrying value = $60,000 − $22,500 = $37,500
– Proceeds = $40,000 → Gain = $40,000 − $37,500 = $2,500
Disposal journal entries:
– Debit Cash $40,000
– Debit Accumulated Depreciation $22,500
– Credit Equipment $60,000
– Credit Gain on Disposal $2,500
Financial-statement and ratio effects: short checklist with a small numeric illustration
– Capitalize: asset appears on the balance sheet; expense recognition is spread over useful life via depreciation. This typically increases current-period profit relative to immediate expensing (because only depreciation, not full cost, hits the income statement in year 1) and increases assets and equity.
– Expense immediately: full cost reduces current-period profit; no asset is recorded.
Illustration (simplified)
Assume, for a single year, other operating income = $100,000 and other operating expenses (excluding the truck) = $30,000.
A) Capitalize truck: depreciation expense = $4,500
– Operating profit = $100,000 − $30,000 − $4,500 = $65,500
B) Expense truck immediately: expense = $60,000
– Operating profit = $100,000 − $30,000 − $60,000 = $10,000
Effect on EBITDA (earnings before interest, taxes, depreciation, amortization)
– Capitalizing raises EBITDA relative to immediate expensing, because depreciation is excluded from EBITDA but an immediate expense would reduce EBITDA.
Key formulas (defined)
– Depreciable base = Cost − Salvage (residual) value
– Annual straight‑line depreciation = Depreciable base ÷ Useful life
– Carrying value (net book value) = Cost − Accumulated depreciation
Practical capitalization decision checklist
1) Future economic benefit: Is it probable the asset will generate benefits beyond the current reporting period? (probable = more likely than not)
2) Measurable cost: Can the cost be reliably measured?
3) Useful life: Will the benefit extend over more than one accounting period?
4) Policy & thresholds: Does the item meet your company’s capitalization threshold and accounting policy?
5) Accounting standard compliance: Does the treatment align with applicable GAAP or IFRS guidance (and lease
and lease accounting rules) before capitalizing.
Common follow‑ups and rules of thumb
– Materiality: If the cost is immaterial to financial statement users, expensing may be simpler and preferred. Materiality depends on company size and reporting needs.
– Thresholds: Many companies set a capitalization threshold (e.g., $1,000 or $5,000) to avoid capitalizing small items. Apply consistently.
– Consistency: Use the same policy each period unless a change is justified and disclosed.
– Review annually: Reassess useful lives, salvage assumptions and impairment indicators.
How to record capitalization — step‑by‑step (common scenarios)
1) Purchase of a fixed asset (paid in cash)
– Initial recognition: record the asset at cost (purchase price + taxes + freight + installation).
– Journal entry:
– Dr Property, plant & equipment (asset) — cost
– Cr Cash — cost
2) Purchase by financing (loan)
– Record asset at full cost.
– Record loan separately.
– Journal entries:
– Dr Asset — cost
– Cr Notes payable (or loan) — principal amount
– Subsequent interest expense recorded each period; if capitalizable (construction), treat as below.
3) Capitalization of subsequent expenditures (improvements that extend useful life)
– If expenditure adds future economic benefits beyond the original estimate, capitalize by adding to asset cost.
– Otherwise, expense repairs & maintenance.
– Journal (to capitalize):
– Dr Asset (increase) — amount
– Cr Cash or Payable — amount
4) Depreciation / amortization
– Systematically allocate cost less residual value over useful life.
– Straight‑line annual depreciation = (Cost − Salvage value) ÷ Useful life (years)
– Journal each period:
– Dr Depreciation expense — amount
– Cr Accumulated depreciation — amount
5) Disposal or derecognition
– Remove asset and accumulated depreciation; recognize gain or loss.
– Journal on sale for proceeds P and carrying amount CV:
– Dr Cash — P
– Dr Accumulated depreciation — accumulated amount
– Cr Asset — original cost
– Dr or Cr Loss/Gain on disposal — CV − P (loss if positive)
Worked numeric example — equipment purchase
– Facts: Equipment cost $100,000; salvage value $10,000; useful life 5 years; straight‑line.
– Depreciable base = 100,000 − 10,000 = 90,000.
– Annual depreciation = 90,000 ÷ 5 = $18,000.
– Year‑1 journal:
– Dr Depreciation expense 18,000
– Cr Accumulated depreciation 18,000
Capitalized interest (brief example)
– Rule: Interest on borrowings for qualifying assets under construction can be capitalized (per IAS 23 / U.S. GAAP).
– Simplified example: Construction expenditures averaged $1,000,000 over the year; actual interest on specific construction loan = $60,000; avoidable interest (approx) = 1,000,000 × (loan rate). If avoidable interest ≤ actual interest, capitalize avoidable interest.
– If avoidable interest = $50,000:
– Dr Asset (construction in progress) 50,000
– Cr Interest payable (or cash) 50,000
– This amount is later depreciated with the asset.
Tax vs book treatment — key differences
– Book (financial reporting) depreciation follows GAAP/IFRS methods (e.g., straight‑line) and useful lives that reflect economic use.
– Tax depreciation follows tax authority rules (in the U.S., MACRS — Modified Accelerated Cost Recovery System). Tax rules often accelerate deductions, creating timing differences and deferred tax.
– Consequence: Capitalizing for book purposes but different tax deductions leads to deferred tax assets/liabilities.
Impairment and remeasurement
– If indicators suggest the asset may not recover its carrying amount, perform an impairment test.
– Under U.S. GAAP, if undiscounted cash flows < carrying amount, record impairment to fair value; under IFRS, compare recoverable amount (higher of fair value less costs to sell and value in use).
– Journal for write‑down:
– Dr Impairment loss (P&L)
– Cr Accumulated impairment / Asset (reduce carrying amount)
Common mistakes to avoid
– Capitalizing routine maintenance costs that do not extend life.
– Forgetting to include directly attributable costs (installation, transport) in asset cost.
– Inconsistent application of thresholds and policies.
– Neglecting impairment triggers or failing to reestimate useful lives.
Quick checklist before capitalizing (condensed)
– Is the future economic benefit probable beyond current period?
– Can cost be measured reliably?
– Does it meet company threshold and policy?
– Is the useful life more than one reporting period?
– Does the treatment comply with GAAP/IFRS and tax rules?
Educational disclaimer
This explanation is educational only and not individualized investment, tax, or accounting advice. For specific accounting treatment for your company, consult a qualified accountant or auditor.
References
– Investopedia — Capitalize: https://www.investopedia.com/terms/c/capitalize.asp
– IFRS Foundation — IAS 16 Property, Plant
– IFRS Foundation — IAS 16 Property, Plant and Equipment: https://www.ifrs.org/issued-standards/list-of-standards/ias-16-property-plant-and-equipment/
– IFRS Foundation — IAS 38 Intangible Assets: https://www.ifrs.org/issued-standards/list-of-standards/ias-38-intangible-assets/
– FASB — Accounting Standards Codification (ASC) (U.S. GAAP): https://asc.fasb.org/
– Deloitte — IAS Plus (practical summaries of IAS 16 and IAS 38): https://www.iasplus.com/
– Investopedia — Capitalize: https://www.investopedia.com/terms/c/capitalize.asp