An item is capitalized when it is recorded as an asset, rather than an expense. This means that the expenditure will appear in the balance sheet, rather than the income statement.
You would normally capitalize an expenditure when it meets both of these criteria:
- Exceeds capitalization limit. Companies set a capitalization limit, below which expenditures are deemed too immaterial to capitalize, as well as to maintain in the accounting records for a long period of time. A common capitalization limit is $1,000. The materiality principle applies to the capitalization concept.
- Has useful life of at least one year. If an expenditure is expected to help the company generate revenues for a long period of time, then you should record it as an asset and then depreciate it over its useful life, which agrees with the matching principle.
Here are several examples to illustrate the concept:
- A company pays $500 for a notebook computer. The computer has a useful life of three years, but it does not meet the company's $1,000 capitalization limit, so the controller charges it to expense in the current period.
- A company pays $2,000 for maintenance on a machine. The payment exceeds the company's capitalization limit, but it has no useful life, so the controller charges it to expense in the current period.
- A company pays $3,000 for a router. The router has a useful life of four years and surpasses the corporate capitalization limit of $1,000, so the controller records it as a fixed asset and begins depreciating it over its useful life.
A special situation is an asset that is being paid for under a leasing arrangement. If the intent of the lease is essentially to finance the purchase of an asset by the lessee, and it meets with the capitalization criteria noted above, then you should record it as a fixed asset. This type of lease is known as a capital lease.