Companies capitalize assets to reduce the operating charges that generally come from such long-term initiatives as business software design, goodwill improvement and patent filings. They do so to translate short-term costs into future benefits, an essential element that helps department heads and segment chiefs record and report accurate financial statements.
Capitalization is the recognition of an expense as part of the cost of an asset on a corporate balance sheet, also known as a statement of financial position or statement of financial condition. The phrase “capitalization of an asset” is incorrect because accounting rules allow only the capitalization of certain expenses or costs, not assets. By capitalizing an expense, a corporate accountant removes it from the income statement and transfers it onto the balance sheet. This entry explicitly acknowledges the fact that the expense has paved the way for future benefits in the firm’s activities. An example of capitalization is the research and development, or R&D, cost that a company incurs in designing software for internal use. Accounting rules allow the business to capitalize R&D charges, once the computer program has proved economically viable and the firm can expect future benefits from using it.
To understand the concept of capitalization, it’s useful to master the term “asset.” This is an economic resource a business relies on to operate and thrive. Accountants set short-term, or current, assets apart from long-term resources. Current resources include cash, accounts receivable and inventories. Long-term assets, also known as tangible or fixed resources, include land and equipment. The key attribute of an asset is that it will serve in a company’s operating activities for a long time. Conversely, an expense is a one-time charge, meaning the business pays for it and does not derive future benefits from the charge.
To capitalize an expense, accounting standards require that corporate bookkeepers post specific journal entries. These norms include generally accepted accounting principles and international financial-reporting standards. Capitalization entries are: debit the asset account and credit the expense account. Crediting an expense account lowers its value, so this entry effectively lowers overall corporate costs and increases net income. Debiting an asset account increases its worth, and therefore the capitalization entry strengths the corporate balance sheet.
Capitalization initiatives affect two interrelated, albeit different, financial statements. Expenses are income statement items, whereas newly capitalized expenses are part of the balance sheet. An income statement is also called a statement of profit and loss, income statement or P&L. It includes a company’s expenses and revenues. Besides assets, a statement of financial condition indicates the organization’s debts and net worth, also known as equity capital. Net worth equals total assets minus total liabilities.