Capitalization is an essential accounting method where a cost is included in the value of an asset and expensed over the useful life of that asset. This approach differs from expensing costs in the period they are incurred. In finance, capitalization frequently refers to market capitalization, which represents the total market value of a company derived by multiplying the number of outstanding shares by the share price.
Key Takeaways
- In accounting, capitalization enables an asset to be depreciated over its useful life, and it appears on the balance sheet rather than the income statement.
- Depreciating assets through capitalization aligns the incurred expenses with the periods the assets provide benefit.
- In finance, capitalization relates to a company’s overall capital structure, encompassing its debt and equity.
- Undercapitalization indicates insufficient capital to cover obligations, while market capitalization highlights a company’s market value by considering its share price and outstanding shares.
Grasping Capitalization
In the realm of accounting, capitalization is a rule that identifies cash outlays as assets on the balance sheet rather than immediate expenses on the income statement. In finance, it assesses a firm’s capital structure, which includes the cost of capital in forms such as stock, long-term debt, and retained earnings.
Types of Capitalization
Accounting
In accounting practices, companies must follow the matching principle, which mandates recording expenses in the same accounting period in which the related revenue occurs. For example, basic office supplies are typically expensed immediately, while larger equipment, like computers or manufacturing devices, which benefit the business over multiple periods, are capitalized. These are usually referred to as fixed assets.
Costs associated with fixed assets are documented in the general ledger at the historical cost of the asset. These assets are then depreciated over time. This practice, termed as depreciation (or amortization for intangible assets), spreads out the expense over the asset’s useful life, allowing the balance sheet to reflect the ongoing use and depreciation of the asset.
The Financial Accounting Standards Board (FASB) outlines that leases exceeding twelve months must be capitalized, acknowledging both assets and liabilities on the balance sheets to fairly represent the lease’s rights and obligations.
Finance
In finance, capitalization also refers to a firm’s capital structure. It can denote the book value cost, encompassing long-term debt, stock, and retained earnings, or market value, which varies with the company’s share price.
For instance, if a company has one billion outstanding shares priced at $10 per share, its market capitalization is $10 billion. Companies categorized as large-cap typically have extensive market capitalization.
Furthermore, companies can appear overcapitalized or undercapitalized, where the former indicates excessive profits with less need for external funding. Companies strive for overcapitalization to enable investment in opportunities, ensure returns to investors, and stabilize profitability.
Capitalization Thresholds
Businesses establish their capitalization thresholds based on their industry and size. Significant discrepancies exist—a small retail shop may set its threshold at $500, while a major technology corporation might set it at $10,000.
Miscalculations in capitalization can distort financial statements; incorrect expensing reduces net income and taxes temporarily, whereas incorrect capitalization inflates net income and overstates asset values.
Essential Questions on Capitalization
What Does Capitalization Mean in Accounting?
Capitalization in accounting involves classifying a cash outlay as an asset on the balance sheet rather than an expense on the income statement. Costs of purchase like computers and office infrastructure aren’t expensed directly, but recognized as historical costs and depreciation follows to allocate the costs over time.
How Does Capitalization Impact Leased Equipment?
Capitalization for leased equipment means converting an operating lease to a capital lease, treating the lease as a purchased asset registered as part of a company’s assets. All leases over twelve months need to be capitalized.
What Does Capitalization Mean in Finance?
In finance, capitalization assesses a firm’s capital structuring—summarizing total long-term debt, stock, and retained earnings as book value, or alternatively calculated through market capitalization based on stock price.
What Costs Can Be Capitalized?
Costs benefiting future periods should be capitalized and depreciated during the period they render benefit. Usual capitalizable expenses include development costs, construction expenses, and significant equipment purchase.
What Is a Capitalization Strategy?
Small businesses initiate operational plans needing clear capitalization strategies illustrating efficient use of limited resources for sustainability. These could include raising private equity, debt application, or injecting personal capital to achieve a viable business continuity plan.
The Bottom Line
Capitalization encompasses varying perspectives in accounting and finance. For accounting, long-term assets aligning with corporate future benefits are capitalized whereas, in finance, the focus is more toward an organization’s structural financing. Understanding and applying capitalization thoroughly aids companies in strategic planning, improving financial health and stability.
Related Terms: Market Capitalization, Depriciation, Amortization, Capital Lease, Fixed Assets.
References
- Financial Accounting Standards Board. “Leases (Topic 842)”, Pages 2-3.
