Small business owners and CEOs often ask us for advice on how to formulate a capitalization policy for their companies. To persons outside of accounting, the term “capitalization policy” may conjure up thoughts of junior high English and the rules of when to capitalize on persons, places and things.
However, when talking about accounting, capitalization has to do with how a company accounts for the purchase of items necessary for the operation of the business.
Capitalization’s effects on your business's financial statements
This article will help you understand: the accounting concept of capitalizing assets, how capitalization works, and why that’s important. Once you understand that, we will explain how to set up a customized capitalization policy for your business.
By having a written capitalization policy, your company will have set parameters to follow to help decide how to record and account for the costs of business expenditures.
When to Capitalize
With every purchase, a business must decide whether to:
- Capitalize it as a fixed asset (and let it impact the balance sheet)
- Expense the purchase (and let it hit the income statement)
Capitalization involves “depreciating ” or “amortizing” a portion of the purchase price of an asset at regular intervals over a set period of time.
The process records the cost of an asset by adding it to the balance sheet, which increases the worth of the company, and reduces its value to the company over its useful life by a series of monthly or annual journal entries.
The decision whether to capitalize an asset or not is a critical business issue because it could influence the profits or losses of a business. The P & L results, in turn, can affect the business’s net worth, its tax liability and potentially debt covenants – the financial ratios required by a lender.
Because this has such a big impact on the value of a company, the accounting profession and the IRS have established guidelines on what is considered a fixed asset versus an expense. To understand those guidelines, you first need to understand the difference between the two types of assets.
A fixed asset is a long-term resource used in the operation of a business such as property, plant or equipment – usually, a new or replacement purchase that is a major expense for the business.
The key qualifications of a fixed asset are:
- The item must have a useful life of one year or more
- Must be productive in business operations
- Investments such as vacant land or buildings would not be considered fixed assets because they are not currently used in conducting business
An expense is a business resource that will expire or will be consumed by the business within one year or the normal operating cycle of the business – depending on whichever time period is longer.
A normal operating cycle is considered the time period a business takes to buy and sell inventories, including collecting payments and paying any creditors.
GAAP Fixed-Asset Inclusions
Fixed assets can include costs beyond the base purchase price of an item. The Generally Accepted Accounting Principles (GAAP) allow for various inclusions in fixed asset costs.
When calculating the price of a fixed asset for capitalization, companies are permitted to include expenses related, or necessary, to the purchase.
GAAP standards allow the following costs to be tacked on to the purchase price when capitalizing a fixed asset:
- Related sales taxes
- Labor and construction costs to produce the item
- Assembly and installation costs
- Import duties
- Inbound shipping and handling costs
- Property site preparation costs, closing costs, title and mortgage fees
- Professional fees such as architects and inspectors
- Repairs and maintenance that keep the asset in efficient operating condition during its useful life (such as adding a new roof to a building)
- Interest costs on loans incurred for expenditures to maintain or restore the operation of an asset
IRS Fixed-Asset Guidelines
The Internal Revenue Service has established “tangible property” regulations governing a business’s fixed asset record keeping. The IRS rule states that fixed assets, at certain thresholds, should be capitalized by a business.
For example, say that the purchase price of a truck for a lawn care business is $50,000. The expenditure would be treated as a fixed asset, because the purchase meets the two requirements of a fixed asset by:
- Having a useful life of one year or more
- A function in business operations.
Assuming that the truck has a useful life of ten years, the business would capitalize (or depreciate) $5,000 a year for ten years. If the truck gets a new engine during that time period, prolonging its use, the engine cost would be added to the remaining value of the fixed asset and incorporated into the depreciation schedule.
On the other hand, when the truck undergoes scheduled maintenance, those charges are deducted as an expense of the business because they do not materially improve the value of the vehicle or increase its years of service. Those costs are just ordinary costs of using the asset.
A rule of thumb to use when totaling fixed-asset expenditures is to ask whether the components are functionally interdependent - also known as a unit of property.
An example of interdependency is buying new tires for that truck, which cannot run without tires. Therefore, the truck and its four new tires are deemed a unit of property for accounting purposes.
Another helpful technique to determine whether expenditures should be capitalized is to use the BAR test. The IRS says a purchase must be capitalized if it results in a betterment (B), adaptation (A) or a restoration (R ) of the unit of property.
If the purchase does not meet the BAR test, it should be considered an expense and deducted accordingly on the income statement.
IRS Fixed-Asset Thresholds
The IRS suggests you chose one of two capitalization thresholds for fixed-asset expenditures, either $2,500 or $5,000. The thresholds are the costs of capital items related to an asset that must be met or exceeded to qualify for capitalization.
A business can elect to employ higher or lower capitalization thresholds. However, the IRS requires that a business uses the same threshold for tax purposes that it uses for accounting purposes.
How Capitalization Works
Now that you know how to identify fixed-asset expenditures in your business, how should you go about capitalizing them? You must go through the following exercise for each potential fixed-asset purchased by your business:
- Find out the base acquisition cost of the fixed asset
- Add to the base price any costs related to securing the asset (as outlined by GAAP and IRS policies)
- Set an expected useful life for the fixed asset (in years or months)
- Divide the total cost of the fixed asset (2) by the time factor (3)
- Depreciate the resulting amount on the books.
- You can record depreciation annually or monthly. We strongly recommend monthly as it’s a true cost of the business and it's needed to show the true profit or loss each month. Plus a monthly entry avoids a major adjustment at the end of the year just to get a tax return done.
Writing a Capitalization Policy
We recommend that all businesses establish a capitalization policy in writing. A written capitalization policy will help your bookkeeper and accountants prevent immaterial expenses from appearing on the balance sheet. In addition, the policy will provide these benefits:
- Ensure accounting consistency
- Reduce record-keeping expenses
- Assist in defense of the business in case of an IRS audit
- Provide a basis for constructing a capital asset budget
The act of identifying and capitalizing fixed-asset costs can be tricky and time-consuming. However, creating and using a capitalization policy throughout the company can have significant accounting benefits for your business.
By setting fixed-asset thresholds and requirements, you will ensure a proper balance between expenses and assets appropriate for your business operation. Most importantly, your monthly financial reports will reflect the true financial picture for your company and point towards operational business success.