When it comes to understanding capitalization, one of the biggest areas that need clarification is understanding expenses versus fixed assets. But in today's post, we're going to cover the basics of capitalization, along with important differences between expenses and fixed assets, to help you get the information you need to move forward.
Let's begin by defining capitalization and explaining the two primary types of capitalization: one that applies to accounting and one that applies to finance.
When it comes to accounting, Investopedia explains:
"Capitalization is an accounting rule used to recognize a cash outlay as an asset on the balance sheet—rather than an expense on the income statement. The cost of fixed assets, such as computers, cars, and office buildings, is recorded on the general ledger as the asset’s historical cost and not expensed in full against earnings in the current accounting period. These costs are said to be capitalized, not expensed."
As it applies to finance, Investopedia explains:
"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. The market value cost of capital depends on the price of the company's stock. It is calculated by multiplying the price of the company’s shares by the number of shares outstanding in the market."
(You might also want to give this post a read next: 3 Things You Need to Know About Good Investment Returns)
For today's purposes, however, we will focus primarily on capitalization as it applies to accounting. Specifically, we'll talk about why the differences between expenses and fixed assets matter.
There are several important differences between the terms that can have a big impact on small businesses. To start, let's look at some examples of expenses and fixed assets.
Your small business expenses include things that are useful day-to-day but won't add value to your business beyond a year.
They can include things like:
Fixed assets are long-term assets that can add value to your business beyond a year.
Businesses use these assets to produce goods and services. And, they can depreciate over time (except land in most cases), which has some tax benefits associated with it if their value is high enough.
(Speaking of tax benefits, check out these tax-decreasing strategies for small business owners next)
They can include things like:
Now, back to capitalization. What does it have to do with expenses and fixed assets?
On the general ledger, you can record the cost of fixed assets as the asset’s historical cost. That means these costs are capitalized rather than expensed.
As for why this is sometimes beneficial for small businesses and tax purposes? Well, you don't expense these assets in full against your earnings in the current account period the way expenses are.
(On the topic of expenses, read this post next to discover the best software for categorizing expenses)
That means your business could theoretically make a big purchase and expense it over several years. Because you use these fixed assets over a period of time for revenue generation, a certain amount of the cost is issued to each accounting period. This is depreciation. In the case of intangible assets, however, it's amortization.
Capitalization is just one important component of small business taxes that's worth learning more about. But we know how overwhelming the world of taxes and bookkeeping can be for small businesses. And that's why we're here to help!
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