The terms "capitalization" and "amortization" refer to the same principle when talking about business assets -- spreading the cost of the assets over a number of years, as opposed to accounting for their full cost at once. Capitalization is a broader term, while amortization is a special case. Here's an overview of capitalization and amortization, and the assets that each may apply to.
What does capitalization of an asset mean?
When a business acquires or creates an asset that is of long-term use, it can be a good idea to account for the expense incurred over a number of years. For example, if you acquire a piece of machinery that has a useful lifespan of 10 years, you can choose to deduct a portion of the purchase price each year for the next decade, instead of claiming the entire cost as a business expense this year.
Business assets, such as the types I'll discuss in the next section, can either be depreciated using the straight line method (equal amounts each year) or the declining balance method (higher depreciation in early years).
What types of assets can be capitalized?
For an asset to be capitalized, it needs to meet the following criteria:
- The business needs to own the asset. In other words, rented equipment isn't eligible.
- The asset must be used to conduct business activities.
- The asset must have a determinable useful lifespan, and it must be greater than one year.
Many types of business assets can fulfill these requirements. Some common examples of assets that can be capitalized include, but are not limited to:
- Buildings/real estate. (Note: Land cannot be capitalized. The whole principle behind capitalization is that the assets will lose value over time -- buildings need to be replaced, computers become outdated, and so on. Land, on the other hand, doesn't naturally depreciate over the years.)
- Machinery and equipment.
- Vehicles used for business purposes.
- Computers, printers, and the like.
On the other hand, expenses such as advertising, R&D costs, and marketing don't result in an acquired asset that demonstrably loses value over a period of years and therefore cannot be capitalized.
Do businesses have to capitalize these assets?
Companies may choose whether or not to capitalize certain assets. For example, if you own a home-based business and you spend $1,000 on a new computer, you may decide that you'd rather have the full $1,000 business expense deduction this year instead of spreading it out.
Amortization: A special case for intangible assets
Notice that capitalization applies to tangible assets -- things that you can see and touch. Some business assets are intangible, meaning that they aren't physical property but still add value to the company. Examples of intangible assets include business start-up costs, acquired trade names, licenses, patents, and trademarks.
For accounting purposes, these are expensed with a special form of capitalization known as amortization. Assets that fall under the IRS's amortization guidelines must be amortized over a 15-year period, and an equal amount of depreciation must be taken each year.
What is the benefit of capitalizing assets?
There are a few reasons businesses choose to capitalize and amortize their assets. While capitalization has little, if any, long-term effect on shareholders' equity, spreading out expenses over time does lead to a more consistent stream of income than simply deducting business expenses.
And because capitalized expenses are lower on a per-year basis, this practice can increase a business' profitability in the short term, which can serve to boost valuation metrics.
Understanding capitalization is just one part of the investing process. If you'd like to keep learning, or if you think you're ready to jump into the investing world, head on over to our Broker Center. We have plenty of resources to help you get started.
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