Capitalization Required by GAAP
Capitalization is a reference to amortizing costs through the lifespan of an asset in depreciation. Any time a business moves costs out through a time period to better match cost with product value it is known as capitalization. While major assets can be capitalized through depreciation, other projects can be capitalized by assigning costs to particular stages of production or delivery. Generally accepted accounting principles (GAAP) require specific methods for capitalization, especially when it comes to depreciation.
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PPE
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PPE stands for property, plant and equipment, the three general headings that GAAP requires to be capitalized. In general, if a business has a capital asset, its cost must be capitalized. This includes not only tangible assets, such as equipment, but intangible assets, such as patents. There is a time frame limit of one year -- any shorter consumption period for an asset does not required capitalization at all, because capitalization typically occurs on a year-to-year basis.
GAAP Methods
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The GAAP method for capitalization of costs is known as full absorption. Full absorption costing seeks to assign all possible costs to a project to fully account for its expenses in the most accurate way possible. This is why depreciation is allowed. A company may have to pay for an asset with an upfront charge, but the value it gets from a long-term asset stretches over years. So GAAP requires that the cost matches the value, amortizing the expense out even though the company might have paid for it immediately.
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Government Methods
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Government methods and GAAP methods do not always agree. For example, the IRS may not count all production and pre-sale costs in the same categories as GAAP. The government also allows a number of exemptions and standards that GAAP does not entertain, because they do not follow the matching principle, the principle that says costs must be logically assigned. The government-allowed methods of depreciation, for example, set lifespan categories on assets to create a depreciation rate for taxation, but GAAP methods do not allow this.
Noncompliance
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In other situations, GAAP methods are often used to determine whether a business is meeting certain government standards. This occurs with issues of compliance. A company may capitalize software projects according to GAAP, but may too freely capitalize vague projects in order to boost income reports. While GAAP deals in specifics, from a broad perspective, it requires company honesty, and understating or overstating expenses, even while following GAAP, can lead to noncompliance and audit failure.
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