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Capitalize is a term used to refer to an item that is recorded as an asset and not expense. This means that the company’s expense will be recorded in the Balance Sheet rather than the Income statement. This could be beneficial for the company as acquiring new assets with long-term lifespan reduces costs.
You can capitalize an expense if the purchase meets the following two criteria:
Every company set a capitalization limit. Expenditures done at that limit can be capitalized. Expenses under the limit will be considered too immaterial to capitalize.
If the company incurs expenses on an item that can help the company gain profit for at at least a year, the company will record the item as an asset and depreciate its value based on the useful life.
Capitalizing an asset has various benefits. One of the major benefits is that it helps increase the company’s asset balance without affecting the liability balance. This will help many financial ratios to appear favourable. However, this benefit should not be the motivation for capitalizing an expense. It is important to thoroughly meet the criteria mentioned above.
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Company ABC has a capitalization limit of Rs. 50,000. The company purchases a computer for Rs. 30,000. The computer has a life value of 3 years. However, the computer does not meet the company’s Rs. 50,000 capitalization limit. Therefore, the controller charges the expense to the current period.
The company incurs an expense on the maintenance of the electricity generator. The payment for the equipment costs the company Rs. 55,000. Since the cost has gone beyond the capitalization limit but has no useful life, the controller will charge the expense in the current period.
Company ABC purchases another computer for Rs. 50,000 and the product has a useful life of 5 years. This meets both the criteria and therefore the controller will record it as a Fixed Asset. The controller will begin depreciating it over its useful life.