What is Capitalization?

Capitalization is an accounting method in which a cost is included in the value of an asset and expensed over the useful life of that asset, rather than being expensed in the period the cost was originally incurred. In finance, capitalization refers to the cost of capital in the form of a corporation's stock, long-term debt, and retained earnings. In addition, market capitalization refers to the number of outstanding shares multiplied by the share price.

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Capitalization

Understanding Capitalization

Capitalization has two meanings in accounting and finance. In accounting, capitalization is an accounting rule used to recognize a cash outlay as an asset on the balance sheet, rather than an expense on the income statement. In finance, capitalization is a quantitative assessment of a firm's capital structure.

Key Takeaways

  • In accounting, capitalization occurs when a cost is included in the value of an asset.
  • In finance, capitalization or book value is the total of a company's debt and equity.
  • Market capitalization is the dollar value of a company's outstanding shares and is calculated as the current market price multiplied by the total number of outstanding shares.

Capitalization in Accounting

In accounting, the matching principle requires companies to record expenses in the same accounting period in which the related revenue is incurred. For example, office supplies are generally expensed in the period when they are incurred since they are expected to be consumed within a short period of time. However, some larger office equipment may provide a benefit to the business over more than one accounting period. These items are fixed assets, such as computers, cars, and office buildings. The cost of these items are recorded on the general ledger as the historical cost of the asset. Therefore, these costs are said to be capitalized, not expensed.

Capitalized assets are not expensed in full against earnings in the current accounting period. A company can make a large purchase but expense it over many years, depending on the type of property, plant, or equipment involved. As the assets are used up over time to generate revenue for the company, a portion of the cost is allocated to each accounting period. This process is known as depreciation or amortization.

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 included on the balance sheet as part of the company's assets. The Financial Accounting Standards Board (FASB) issued a new Accounting Standards Update (ASU) in 2016 that requires all leases over twelve months to be both capitalized as an asset and recorded as a liability on the lessee's books, to fairly present both the rights and obligations of the lease.

Generally, a company will set "capitalization thresholds." Any cash outlay over that amount will be capitalized if it is appropriate. Companies will set their own capitalization threshold because materiality varies by company size an industry. For example, a local mom and pop store may have a $500 capitalization threshold, while a global technology company may set their capitalization threshold at $10,000.

Financial statements can be manipulated when a cost is wrongly capitalized or expensed. If a cost is incorrectly expensed, net income in the current period will be lower than it otherwise should be. The company will also pay lower taxes in the current period. If a cost is incorrectly capitalized, net income in the current period will be higher than it otherwise should be. In addition, assets on the balance sheet will be overstated.

Capitalization in Finance

Another aspect of capitalization refers to the company's capital structure. Capitalization can refer to the book value cost of capital, which is the sum of a company's long-term debt, stock, and retained earnings. The alternative to the book value is the market value. The market value cost of capital depends on the price of the company's stock. It is calculated by multiplying the price of the company’s shares by the number of shares outstanding 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 (more than $10 billion); companies with medium market capitalization are referred to as mid caps ($2 - $10 billion); and companies with small capitalization are referred to as small caps ($300 million - $2 billion).

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. Undercapitalization occurs when there's no need for outside capital because profits are high and earnings were underestimated.