Advantages of Capitalization in Accounting
Capitalization is recording an item that was traditionally an expense as an asset in the balance sheet instead of the profit and loss account. For instance, capitalization occurs when you record research and development expenses as an intangible asset on the balance sheet instead of treating it as an expense on the income statement. Capitalization of an expenditure shows that it has a future economic benefit. Generally, it strengthens the balance sheet of the business and offers a number of advantages.
Capitalization increases a company’s value by increasing the value of its assets. For instance, if a company purchases a manufacturing machine from Taiwan for $5 million and spends an additional $1.2 million to ship and install it, generally accepted accounting principles -- GAAP -- allow addition of those shipping and installation costs to the asset value in the process of capitalization. This increases the value of the company’s tangible assets from $5 million to $6.2 million. Similarly, when a company capitalizes its lease payments, it increases property value in the tangible assets section.
Capitalization leads to higher profits compared to expensing. During the first years of capitalization, there is increase in profitability in terms of return on assets and return on equity of the firm. Capitalization of long-term assets spreads the expenses over time through depreciation, which normalizes the income of the business. Expensing, on the other hand, reduces the income and distorts net income.
After capitalization, your business will yield higher profitability in the short term. Some liquidity ratios will also show higher liquidity, especially ratios associated with cash flow from operations. Equity turnover of the business also increases after capitalization, because you will report higher value of fixed assets, higher net income and lower equity. This also implies that return on equity and return on assets increase because the business is reporting higher returns. Since the value of your assets and earnings before tax increase after capitalization, solvency ratios recorded in the business are better.
A business can choose to capitalize or expense its costs arising from a fixed asset. However, GAAP requires capitalization of assets that have a long-term effect on the future value of the asset for tax and depreciation purposes. Not all expenses are eligible for capitalization -- only those that are relevant for multiple accounting periods. For instance, installation costs, exploration costs and land improvements are eligible for capitalization, but costs for repair and legal fees should be expensed. Consult a professional accountant or finance expert if you are not sure about expenses that are eligible for capitalization to avoid a violation of GAAP.