A capitalization policy is an important accounting method that establishes a monetary threshold for determining when a purchase should be treated as a fixed asset on the balance sheet rather than an operating expense on the income statement. For example, a capitalization policy may state that any equipment, furniture, vehicle, or other long-term business asset costing over $2,000 is capitalized and depreciated over time rather than being expensed in the period it was incurred.
Setting an appropriate capitalization threshold allows organizations to more accurately reflect the value of major business assets on their financial statements. Without capitalizing significant purchases, the balance sheet would understate the true property, plant and equipment owned by the company. At the same time, expensing major asset purchases all at once would distort net income in the year of acquisition.
Why Capitalize Fixed Assets?
The rationale behind capitalizing fixed asset purchases above a set threshold is that more expensive, long-lasting items should have their costs allocated over their estimated useful lives rather than hitting the income statement all at once. This matches expenses to the periods that are benefiting from the asset. It also avoids significant fluctuations in net income from major asset purchases and dispositions.
To qualify as a fixed asset, an item should generally have a useful lifespan of over one year. Common examples of fixed assets include buildings, machinery, vehicles, computers, office equipment, furniture, and other tangible items used in operations. Many intangible assets like patents, trademarks, and software can also be capitalized.
Depreciation of Fixed Assets
Unlike operating expenses, fixed assets are depreciated over time based on their estimated economic usefulness. This contrasts with smaller supplies and other operating expenses which are fully expensed in the period they are incurred. There are several standard depreciation methods, with straight-line depreciation being the most common. This spreads out the cost evenly over the asset's lifespan.
Factors in Setting Capitalization Thresholds
Capitalization policies tend to range anywhere from $500 to $5,000, but can vary more widely than that based on factors like industry, organization size, asset mix, and useful lives. Most policies set the threshold between $1,000 and $5,000. There's no one-size-fits-all universal capitalization policy that is ideal for every company.
The appropriate threshold can differ greatly depending on whether the business relies heavily on long-lived assets like manufacturing equipment or largely utilizes supplies and low-cost office equipment. Service industries tend to capitalize less than manufacturing companies. The goal should be setting a customized policy that accurately reflects the true economic usefulness of the asset classes commonly acquired.
Aligning Policy with Operations
When setting their capitalization policies, businesses should consider useful asset lives, maintenance cycles, replacement budgets, accounting system capabilities, and various operational factors. Internal needs and industry benchmarks can both provide guidance. For example, an automotive factory may capitalize assets over $2,500, while a software firm capitalizes those over $1,000 due to shorter technology life cycles.
Nonprofit and Church Considerations
Nonprofits and churches also need capitalization policies tailored to their operational realities. Factors like cash flow constraints, donation dependency, grant restrictions, and limited revenue sources may warrant higher capitalization thresholds compared to for-profit entities. Proper tracking and management of fixed assets is critical, so the policy threshold should align smoothly with internal asset monitoring procedures.
Periodic Policy Reviews
Organizations should periodically review their capitalization thresholds and benchmark against peers to ensure the policy remains relevant as operational needs evolve. For example, inflation or technology changes may necessitate adjustments. Finding the right balance is key – not so high that assets are understated, not so low that normal expenditures are overcapitalized. An optimal capitalization policy accurately reflects economics.
In summary, a well-designed capitalization policy that is customized to an entity's operational asset mix and industry helps ensure financial statements appropriately categorize expenditures and report asset values. Reviewing capitalization policies periodically and keeping thresholds aligned with business realities is key to proper accounting and financial statement accuracy.
