Definition: Capitalization is recognizing the expense of a long-term asset over a specified period of time, which is typically defined by the useful life of the long-term asset. When an entity elects to capitalize an expense, it’s reducing the amount of expense associated with the asset in a given period by spreading recognition of the expense over the useful life of the asset.
What Does Capitalize Mean?
What is the definition of capitalize? Typically speaking, entities maintain a capitalization policy, and they capitalize large investments that are recognized as an asset on the balance sheet. These assets provide benefit to the business over a specific useful life, and therefore the entity can spread the recognition of the cost (expense) of the asset over that time period. There are many benefits to capitalization, but the most significant benefit is the expense reduction in a given period of time. As it relates to the capitalization of assets, such as a building, the expense is recognized as depreciation expense each period.
What does it mean to capitalize an expense? While a variety of policies or rules may define the useful life of a long-term asset owned by an entity, the useful life is considered to be an estimate. Entities use the estimated useful life of an asset to defer the purchase cost of the asset over the estimated useful life. Typically, a straight-line methodology is applied to the calculation, which means the organization equally spreads recognition of the expense over the useful life of the capitalized asset.
Example
Let’s pretend a company recently purchased office furniture that they plan to use in a building. It was a large purchase, comprised of desks, chairs, filing cabinets, and other standard office furniture accessories. The total cost of furniture was $84,000. Upon receipt of the furniture at the building, the company paid the invoice, and the accountant entered the $84,000 expense into an asset account called Work in Process (WIP). This account accumulates all expenses that are intended to be long-term assets, but they have not yet been put into use, and therefore cannot yet be capitalized.
After installation of the furniture, the office is ready to go! The assets have been put into use, and the accountant can capitalize the $84,000 cost of furniture into long-term assets on the company’s balance sheet. The estimated useful life of the furniture, as defined by the company policy, and IRS tax code, is 7 years. So, how much expense do you think the company should recognize each month? The answer is $1,000 per month, or ($84,000 cost ÷ 7 years) ÷ 12 months. This straight line calculation of the capitalized cost will ensure the company recognizes an appropriate amount of depreciation expense each year, no matter what month the furniture was put into use.
Summary Definition
Define Capitalize: To capitalize an asset means to defer the recognition of the expense (cost) associated with the asset over the useful life.
