Accounting principles define an expense as an outflow of economic resources during a period. Although it may sound adverse, expenditure is crucial to running any business. Most companies incur expenses in various areas, which they charge for a specific period. These items become a part of the income statement and reduce profits for that period.
However, accounting standards may require companies not to charge expenses for one period. These items then become a part of another period based on the requirements of that standard. This process falls under the definition of capitalization. It is crucial to determine which expenses companies can capitalize and distinguish them from others.
What is the meaning of Capitalize in Accounting?
The term capitalize may have a different meaning in other contexts. However, in accounting, it refers to companies not charging expenses for a specific period. Instead, these expenses get “capitalized” and become an asset. Based on the accounting standards dictating the process, these assets become an expense in the income statement at a later date.
The items that companies can capitalize in accounting are not specific. Instead, each accounting standard defines the expenses that become a part of the asset’s cost. For example, IAS 16 requires capitalizing any expenses incurred in bringing an asset to its current working location and condition. However, the same rules do not apply to inventory, where IAS 2 applies.
How does Capitalization work?
The primary concept of capitalization is to defer charging an expense to another period. Instead, companies must recognize that expense as an asset for that time. Once that expense meets the definition of expenditure set by accounting standards, companies can charge it to the income statement. For example, companies do not write off the price paid to acquire a fixed asset. Instead, they depreciate it over time.
The primary distinction between costs that companies can capitalize comes from two types of expenditures. The first is capital expenditure, which involves expenses incurred on acquiring or maintaining assets. These are items companies can capitalize as part of the asset’s cost. On the other hand, there are revenue expenditures. These are expenses incurred to run the business.
Once companies capitalize an expense, it does not stay as an asset on the balance sheet forever. Instead, companies determine the correct time to write them off through the income statement. As stated above, the guidance usually comes from accounting standards. Once the capitalized cost fulfills the criteria, it becomes an expense on the income statement.
What is the importance of Capitalization in Accounting?
Capitalization is a crucial topic in accounting. It allows companies to conform to the matching principle. Primarily, this principle requires companies to charge an expense for a period in which it helps generate revenues. Sometimes, companies encounter an expenditure before that period. Companies cannot charge for that period.
Therefore, companies use capitalization to record expenditure as an asset. This practice conforms to accounting principles and standards. Once that expenditure helps generate revenues in a period, companies charge it to the income statement. Therefore, it helps provide a more accurate picture of the company’s operations and financial performance.
However, capitalization does not impact financial performance and the income statement only. It also affects the balance sheet where companies record the capitalized expenditure. It forms the basis for companies to recognize assets, including fixed assets and inventories. Therefore, capitalization is crucial in providing an accurate picture of a company’s financial position and health.
The meaning of capitalize in accounting relates to the capitalization process. It involves “capitalizing” an expense as an asset and charging it to a different period. Primarily, it helps conform to the matching principle in accounting. Capitalization of capital expenditures is crucial in reporting accurate figures in the financial statements.
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