Capitalization is the process of recording the cost of purchasing an asset and depreciating it over its useful life, rather than expensing it when purchased.
When costs are expected to provide benefits over a period of more than a year, they should be capitalized, whereas costs with benefits that last less than a year are expensed when incurred.
- Capitalizing – The expense incurred to purchase the asset is recognized on the balance sheet, the asset value is then reduced through annual depreciation or amortization expenses on the income statement.
- Expensing – The total cost of purchase is recorded as an expense on the income statement in the same period in which the expense was incurred.
Based on the useful life of the asset, it is expensed over time until no longer useful in terms of economic output.
If the asset is a fixed asset like property, plant and equipment, the capitalized expense would be reflected as depreciation expense on the income statement. If the asset is an intangible asset like goodwill, the capitalized expense would be reflected as amortization on the income statement.
For example, $1,000 was spent to purchase equipment. This equipment is listed on the balance sheet as an asset worth $1,000 and depreciated over the useful life rather than as an expense in the year it was purchased. For tax purposes, expensing this type of cost results in additional deductions in the year in which the assets are placed into service.
Writing your capitalization policy
It is useful for businesses to adopt their own customized fixed asset capitalization policies that can act as guides as to which expenditures should be capitalized. These policies should consider the size of the business, the use of customary capital items, revenues and expenses, and compliance needs -- both the tax depreciation report and property tax (if applicable) as well as for financial reporting purposes.
Most companies set minimum purchase thresholds for an item to be considered a fixed asset. The purpose of the capitalization threshold is to prevent the business from placing immaterial expenses on the balance sheet instead of recognizing them as an expense in the period incurred. There is no set value for a capitalization threshold from a financial reporting perspective, but the Internal Revenue Service indicates that most items with a useful life of more than one year should be capitalized.
When determining whether the equipment purchased for $1,000 in our example should be capitalized and depreciated over the next five years, there are two things to consider: First, the de minimis rule. This allows for the expense of any item to be capitalized if the cost of acquisition of that asset does not significantly skew net income. These expenses cannot make up a large percentage of the total expenses, resulting in extraordinarily low income. A good rule of thumb is that such expenses should be less than 0.1% of the gross receipts for the year, and/or 2% of total depreciation and amortization expenses. The IRS de minimis safe harbor allows for expenses of up to $2,500 per item or invoice to be deducted in the year in which it was incurred.
Second is the economic useful life of the asset. As mentioned earlier, if the asset useful life would be one year and has no value afterwards, then it could be expensed. The only consideration here would be the timing as the matching principle comes into play which requires that the business records expenses alongside related revenue earned in the same accounting period. However, if those expenses do not distort the bottom line, there could be an argument made to claim that deduction.
These two items are a good place to start when determining when to expense and when to capitalize. Taxpayers should also take into account the regulations under section 1.263(a) which allow for expenditures to be deducted in the current year if paid for incidental materials and supplies or for repair and maintenance.
A capitalization policy can also be helpful in the construction of a capital asset budget for future periods by identifying which items should be capitalized. The IRS de minimis threshold is increased from $2,500 per item to $5,000 per item for entities with an applicable financial statement following their written policies. Therefore, a written policy is also your best bet to ensure consistency and defend yourself should the IRS contest your expenditures.
Please contact your Mazars professional for additional information.