Capitalization is the recordation of a cost as an asset, rather than an expense. Capitalization is used when a cost is not expected to be entirely consumed in the current period, but rather over an extended period of time. For example, office supplies are expected to be consumed in the near future, so they are charged to expense at once. An automobile is recorded as a fixed asset and charged to expense over a much longer period through depreciation, since the vehicle will be used over a much longer period of time than office supplies.
Capitalization is also based on the concept of materiality. If a cost is too small, it is charged to expense at once, rather than bothering with a series of accounting calculations and journal entries to capitalize it and then gradually charge it to expense over time. The specific dollar amount below which items are automatically charged to expense is called the capitalization limit, or cap limit. The cap limit is used to keep record keeping down to a manageable level, while still capitalizing the bulk of all items that should be designated as fixed assets.
Capitalization is used heavily in asset-intensive environments, such as manufacturing, where depreciation can be a large part of total expenses. Conversely, capitalization may be extremely rare in a services industry, especially when the cap limit is set high enough to avoid the recordation of personal computers and laptops as fixed assets.
If a company constructs fixed assets, the interest cost of any borrowed funds used to pay for the construction can also be capitalized and recorded as part of the underlying fixed assets.
Capitalization can be used as a tool to commit financial statement reporting fraud. If costs are capitalized that should have been charged to expense, current income is inflated, at the expense of future periods over which additional depreciation will now be charged. This practice can be spotted by comparing cash flows to net income; cash flows should be substantially lower than net income.