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Whenever a company purchases an asset with long term value, it must be capitalized. Every asset that is capitalized is then depreciated, which is special form of amortization.
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Capitalization and Amortization
Capitalization is the process by which something that is purchased (usually land, buildings, or equipment) becomes a fixed asset on the Balance Sheet. Amortization is the write-down of an account balance on the Balance Sheet.
When to Use Capitalization and Amortization
Whenever a company purchases an asset with long term value, it must be capitalized. Every asset that is capitalized is then depreciated, which is special form of amortization. Amortization also applies to intangible asset accounts.
- The business must first decide to acquire an asset – this is normally done through purchasing land, buildings or equipment. However it can also include the development of an internal system in certain special cases.
- When a fixed asset is modified or improved, such as putting an addition on a building, that modification can also be capitalized.
- When the asset is identified, finance will capitalize it on the business books.
- It is listed as a fixed asset on the Balance Sheet.
- The purchase is recorded as an Investment Cash Flow on the Cash Flow Statement.
- When an asset is capitalized, the purchase IS NOT included on the Earnings Statement for the period in which it was purchased.
- If the company pays cash, the cash account is decreased. If money is borrowed to pay for the asset, the debt is increased, the value of the loan is placed in cash and then the cash account is decreased to pay for the asset.
- There are special accounting rules that determine the minimum purchase price for assets in different technical categories. If the price is less than the minimum, the asset is treated like a normal expense and it is not capitalized.
- Finance tracks capital expenses closely because of their impact on financial statements and because the business must pay property taxes on fixed assets.
- Since amortization applies to intangible asset and financial accounts, operating managers and project managers seldom have anything to do with amortization.
Hints and Tips
- If you are not certain whether to capitalize something, check with finance. There are numerous accounting standards and tax laws that apply – and these change often. Finance is the expert in this area, they will be able to answer your question.
- Generally businesses want to capitalize as much as they can because money spent on capitalized assets does not show as an expense in the current year and therefore will have a tendency to create a higher Net Income in the current year.
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