A capitalization policy, also known as a capitalization threshold or capitalization limit, is a set of guidelines established by a company to determine the minimum dollar value at which a purchased or acquired asset must be capitalized (recorded as a fixed asset on the balance sheet) rather than expensed immediately. This policy helps businesses differentiate between capital expenditures and operating expenses, which have different tax and accounting treatment.
Capitalization policies vary among companies based on factors such as the organization’s size, industry, and internal accounting practices. Typically, larger organizations have higher capitalization limits, while smaller businesses may have lower limits.
When an asset’s cost falls below the capitalization limit, it is considered an operating expense and is expensed in the current accounting period. This expense has an immediate impact on the company’s income statement, reducing its net income for the period. Conversely, when an asset’s cost is above the capitalization limit, it is considered a capital expenditure and is recorded as a fixed asset on the balance sheet. The asset’s cost is then depreciated or amortized over its useful life, gradually reducing the asset’s value and recognizing the expense on the income statement over time.
Implementing a capitalization policy helps companies maintain consistency in their financial reporting and ensures that material assets are appropriately accounted for. It also ensures that companies comply with accounting standards, such as the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), which require assets to be capitalized if they provide economic benefits beyond the current accounting period.
Example of a Capitalization Policy
Let’s consider a fictional small business, “Mike’s Bike Shop,” to illustrate the concept of a capitalization policy.
Mike’s Bike Shop has established a capitalization limit of $500. This means that any purchased or acquired asset with a cost of $500 or more will be capitalized, while assets costing less than $500 will be expensed immediately.
Here are a few examples of assets that Mike’s Bike Shop may purchase and how they would be accounted for based on their capitalization policy:
- Bicycle Repair Equipment: Mike’s Bike Shop purchases specialized bicycle repair equipment for $800. Since the cost of the equipment exceeds the capitalization limit of $500, the equipment will be capitalized as a fixed asset and depreciated over its useful life.
- Office Supplies: Mike’s Bike Shop buys office supplies for $300. The cost of the office supplies is below the capitalization limit of $500, so they are considered an operating expense and will be expensed in the current accounting period.
- Delivery Van: Mike’s Bike Shop acquires a delivery van for $15,000. The cost of the van is above the capitalization limit of $500, so it will be capitalized as a fixed asset and depreciated over its useful life.
By adhering to the capitalization policy, Mike’s Bike Shop can maintain consistency in its financial reporting and ensure that assets are accounted for appropriately. This approach also helps the bike shop comply with accounting standards and manage its tax obligations by distinguishing between capital expenditures and operating expenses.