What is Capitalizing Assets?
Capitalizing assets simply means you are carrying an asset to balance sheet. It indicates you purchased an asset, the life of which is more than one financial year. In other words capitalizing can be defined as ‘spreading of asset value into number of years equals to the life of the asset by means of depreciation’.
Conditions for Capitalizing an Asset
Normally, there are two conditions when the assets are capitalized
- When the useful life of the asset is more than 1 year the financial year.
- The value of asset is more than the threshold limit set by the company for capitalizing.
Capitalizing Asset Example
Let’s try to understand capitalizing an asset with the help of an example. Supposed Mr. John has a shop near Garden. He wishes to start selling ice cream from that shop. So, he buys a cold storage worth $1500 to store the ice cream. Note that the life of this storage is 10 years. The total expected revenue from this venture is Dollar 20000 for the year and the cost of ice cream would be $18,000. And there are other expenses totally $1,000.
|Particulars||Cash Flow||Profit / Loss|
|Ice Cream Purchase Cost||(18,000.00)||(18,000.00)|
|Other Operating Expenses||(1,000.00)||(1,000.00)|
|Cost of Long-Term Asset i.e. Cold Storage.||(1,500.00)||(1,50.00)|
In the above table, we have taken only 1/10th part of cold storage cost in the profit loss column. It is because the cold storage will be useful for 10 years from now. Let’s take the other side, if we deduct the whole cost of $1,500 we get a loss of $500 in the first year and that is not the right presentation. Is Mr. John would have known that he would make a loss of $500 in the first year he would not have made the investment itself.
Capitalizing Asset and Matching Principle
There is a role of the basic accounting principle i.e. the matching principle behind capitalizing assets. The principle state that you should book only those expenses, which have direct relation in bringing out the revenues of the same period. When we invest in a long term asset, we do not consume the whole asset in the first year or the first financial year itself and that is why we capitalize the assets and depreciate them every year till the life of the asset. In the example also we are capitalizing the cold storage for the same reason.
Benefit of Capitalizing
The primary benefit of capitalizing is that it assists in presenting the right picture of state of affairs of a business. If the principle of booking an asset as an expense in the year of its purchase, it will highly distort the financial statements. In the first year, you will see heavy losses and in the coming years you will see heavy profits.
You will be surprised to know that the concept of capitalizing is widely used for fraudulent practices as well. It is quite obvious that everybody likes to have good profit in the profit and loss account. But, for some reason a business is not able to earn profit in a particular year. On the other hand, showing losses in the financial statement will go against the creditworthiness of the business in the eyes of bankers, shareholders, creditors etc.
At this juncture, managers enter into fraudulent practices by capitalizing expenses which should not be capitalized as per the accounting principles. By doing this, they are able to reduce expenses and thereby show profit in the financial statements.
Capitalizing and Immateriality
It is not necessary to capitalize Each and every small asset which has a longer life. For example stapler used as a stationery items has a life more than 1 year but we need choose not to capitalize this asset looking at the minuscule value of this asset in comparison to the business size. This is where immateriality concept plays a role.
Which Assets to be capitalized?
Following is a list of assets which are normally capitalized apart from the assets whose value is less than threshold limit and one which are consumed within one financial year.
- Capital Leases
- Library Content
- Misc Assets
- Media (Films Generally Expensed)
- Works of Art1,2