Businesses generally account for their purchases in one of two ways -- as expenses reported on the income statement or as capital costs reported on the balance sheet. Depreciation is a little different because it essentially moves capital costs from the balance sheet to the income statement over time. Understanding the difference between capitalization and depreciation is crucial to providing more accurate reporting on financial statements.
Capitalization is essentially the practice of reporting a large expense on the company's balance sheet than on the company's income statement. This is possible because most large purchases -- such as cars or machinery -- remain assets owned by the company that could be sold for cash at some later date. Smaller purchases are usually of items such as office supplies that are expended fairly readily, so they can't be considered assets that the company retains for future sale.
Limits to Capitalization
Not all expenses can be capitalized. Generally, an expense should only be capitalized if its value is retained in the form of an asset. When businesses spend on services such as rent, utilities and salaries, they often cannot record an asset because they gain no marketable items in exchange for their cash outlay. Services that increase the value of an asset, such as construction or renovation of a building, are capitalized. Companies and institutions often develop a capitalization policy based on generally accepted accounting principles that determines a threshold for how large an expenditure can be before it is capitalized.
Depreciation is the practice of expensing the cost of a capitalized asset over time. Many assets cannot be sold later to fully recover the business's cost. This is because of the effects of gradual long-term use on the asset -- for example, a car is more likely to break down the longer it has been operating, so its resale value tends to be less than that of the original purchase. This decay in an asset's value is predictable and the business reports it as a depreciation expense as it takes place.
Capitalization and depreciation are similar and related, but have some key differences in practice. Capitalization is basically moving an expense from the income statement to the balance sheet, while depreciation is the process of moving it back to the income statement over time. Tax authorities usually require businesses to depreciate large purchases over time rather than report them as expenses in the tax year of the purchase. This prevents companies from reducing their income, and lowering their tax liability, if they still retain the ability to sell their assets to meet tax obligations.
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