A capitalization policy is part of a company’s asset acquisition process. National accounting guidelines allow companies to record the purchases of large items as assets rather than expenses. Two standards often exist for a capitalization policy. First, the item must last more than 12 months, which automatically classifies it as a long-term asset rather than a current asset. Second, purchases must be over a certain dollar limit, such as $3,000 US Dollars (USD), but this dollar amount may change per a company’s guidelines.
Companies capitalize assets because it improves their bottom lines. Expensing a large asset purchase can result in a significant income loss on the current period’s income statement. Recording it as an expense also makes it seem as though the item has no value in the near future; this is inaccurate, however, as the company expects the item to last more than 12 months. The capitalization policy corrects these flaws and presents a better financial picture of the company’s assets. Assets also improve the company’s economic wealth, improving the business’s economic wealth.
A company’s capitalization policy typically groups assets into certain categories. Groups may be production equipment, computers, software packages, leased equipment, fabricated equipment, or repairs and maintenance for current long-term assets. All costs associated with these items have specific dollar amounts that meet the capitalization policy. Companies may update the policy for inflation, which naturally increases the cost of items purchased by the business. Department managers receive updates on the policy to ensure all future asset purchases meet the company’s requirements.
An accounting department typically requires an authorized form as part of the capitalization policy. The form may or may not be part of the authorized purchase order from a company’s management team. These individuals approve all purchases requested by employees. Along with the purchase order authorization, accountants often need an authorized form that allows them to capitalize the asset. Incorrectly capitalizing purchases is a major financial misstatement issue.
Depreciation is often a part of a company’s capitalization policy. While the company can record the purchases price — and costs to set up the assets like freight and installation charges — they must represent the use of the asset. Depreciation is the financial entry that represents the use of capitalized assets. Each year, accountants book an expense that indicates the use of the asset. The entry credits a contra asset that reduces the value of an asset as listed on the company’s balance sheet.