Table of Contents
Table of Contents

What Is Capitalization?

By Alicia Tuovila
Updated July 22, 2024
Reviewed by
Natalya Yashina
Natalya Yashina
Reviewed by Natalya Yashina
Full Bio
Natalya Yashina is a CPA, DASM with over 12 years of experience in accounting including public accounting, financial reporting, and accounting policies.
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What Is Capitalization?

Capitalization is an accounting method in which a cost is included in an asset's value and expensed over the asset's useful life, rather than expensed in the period the cost was incurred. Capitalization recognizes a cash outlay as an asset on the balance sheet rather than an expense on the income statement.

Capitalization can also refer to the quantitative assessment of a firm's capital structure the cost of capital in the form of a corporation's stock, long-term debt, and retained earnings.

Key Takeaways

  • In accounting, capitalization allows an asset to be depreciated over its useful life, recognized on the balance sheet rather than the income statement.
  • Capitalization may refer to the book value or a company's total debt and equity.
  • Undercapitalized companies do not have enough capital on hand to finance all obligations.
Capitalization

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Types of Capitalization

  • Accounting: The matching principle requires companies to record expenses in the same accounting period in which the related revenue is incurred. However, assets may benefit a business over more than one accounting period and are often fixed assets like office buildings. The costs of these items are recorded on the general ledger as the asset's historical cost. Therefore, these costs are capitalized, not expensed. Capitalized assets are not fully expensed against earnings in the current accounting period. A company can make a large purchase but expense it over many years, depending on the type of property, plant, or equipment involved.
  • Finance: Capitalization can refer to the book value cost of capital, which is the sum of a company's long-term debt, stock, and retained earnings. The alternative to the book value is the market value, which depends on the price of the company's stock. Market capitalization is the number of outstanding shares multiplied by the share price. If the total number of shares outstanding is 1 billion and the stock is currently priced at $10, the market capitalization is $10 billion. Companies with a high market capitalization are referred to as large caps.

As assets are used over time to generate revenue for a company, a portion of the cost is allocated to each accounting period. This process is known as depreciation for fixed assets and amortization for intangible assets.

Capitalization Thresholds

Generally, a company will set "capitalization thresholds." Any cash outlay over that amount will be capitalized if appropriate. Companies will set their capitalization threshold because materiality varies by size and industry. For example, a small local store may have a $500 capitalization threshold, while a global technology company may set its capitalization threshold at $100,000.

Financial statements can be manipulated when a cost is wrongly capitalized or expensed. If a cost is incorrectly expensed, net income in the current period will be lower than it should be. The company will also pay lower taxes in the current period. If a cost is incorrectly capitalized, net income in the current period will be higher than it should be. In addition, assets on the balance sheet will be overstated.

What Is the Difference Between Undercapitalization and Overcapitalization?

A company can be overcapitalized or undercapitalized. Undercapitalization occurs when earnings are insufficient to cover the cost of capital, such as interest payments to bondholders or dividend payments to shareholders. Overcapitalization occurs when there's no need for outside capital because profits are high and earnings are underestimated.

How Does Capitalization Impact Leased Equipment?

For leased equipment, capitalization is the conversion of an operating lease to a capital lease by classifying the leased asset as a purchased asset, which is included on the balance sheet as part of the company's assets. The Financial Accounting Standards Board (FASB) requires all leases over twelve months to be capitalized as an asset and recorded as a liability on the lessee's books to show the lease's rights and obligations.

What Costs Can Be Capitalized?

Costs that benefit future periods should be capitalized and expensed so that the expense of the asset is recognized in the same period as when the benefit is received. In general, examples of costs that can be capitalized include development costs, construction costs, or capital assets such as equipment or vehicles.

The Bottom Line

In accounting, capitalization refers to long-term assets with future benefits. Instead of expensing costs as they occur, they may be depreciated over time as the benefit is received. In finance, capitalization refers to the financing structure of a company and its book value capital cost.

Article Sources
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  1.  Financial Accounting Standards Board. “Leases (Topic 842),” Pages 2-3.

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