What Is to Capitalize?
To capitalize is to record a cost/expense on the balance sheet for the purposes of delaying full recognition of the expense. In general, capitalizing expenses is beneficial as companies acquiring new assets with long-term lifespans can amortize the costs. This is known as the process of capitalization.
Capitalization may also refer to the concept of converting some idea into a business or investment. In finance, capitalization is a quantitative assessment of a firm's capital structure. When used this way, it sometimes also means to monetize.
There are strict regulatory guidelines and best practices for capitalizing assets and expenses.
The Basics of Capitalization
One of the most important principles of accounting is the matching principle. The matching principle states that expenses should be recorded for the period incurred regardless of when payment (e.g., cash) 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 large delivery truck for daily operations. This truck is expected to provide value over 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.
Capitalizing assets has many benefits. Because long-term assets are costly, expensing the cost over future periods reduces significant fluctuations in income, especially for small firms. Many lenders require companies to maintain a specific debt-to-equity ratio. If large long-term assets were expensed immediately, it could compromise the required ratio for existing loans or could prevent firms from receiving 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 an expense.
The process of writing off an asset, or capitalizing an asset over its life, is referred to as depreciation, or amortization for intangible assets. Depreciation deducts a certain value from the asset every year until the full value of the asset is written off the balance sheet. 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.
- 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 value of the asset that will be assigned is either its fair market value or the present value of the lease payments, whichever is less. Also, the amount of principal owed is recorded as a liability on the balance sheet.
- To capitalize is to record a cost/expense on the balance sheet for the purposes of delaying full recognition of the expense.
- Capitalization is used in corporate accounting to match the timing of cash flows.
- Depreciation and amortization are two common forms of asset capitalization.
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.
The alternative to the book value is market value. The market value 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; 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. Undercapitalization occurs when there's no need for outside capital because profits are high and earnings were underestimated.
Capitalized Cost Versus Expense
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 cost on any transaction is the amount of money used in exchange for 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.
The use of the word capital to refer to a person's wealth comes from the Medieval Latin capitale, for "stock, property."
Limitations of Capitalization
To capitalize assets is an important piece of modern financial accounting and is necessary to run a business. Financial statements, however, can be manipulated—for instance, when a cost is expensed instead of capitalized. If this occurs, current income will be inflated at the expense of future periods over which additional depreciation will now be charged.