The Capitalization of Costs
When a business buys a major piece of equipment or real estate it typically capitalizes = the associated costs. Generally accepted accounting principles (GAAP) provide standardized methods to spread these purchases over a longer time period more closely matched to the time period over which they generate money for the business. It is this matching of the costs through depreciation, amortization or depletion that is known as capitalizing a cost.
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Why Capitalize Costs?
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When costs are spread out over multiple accounting time periods, there is a significant short-term positive impact on a business's financial statements. If the expenses related to the purchase in question were not broken up, they would be directly subtracted from the business's revenue for the year. The bottom-line profit for the business is effectively higher by the capitalized amount. This is considered a more accurate way to represent the impact of capital investment decisions on the business over time.
Capitalizing Excess Costs
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A business can capitalize additional one-time costs related to the construction, installation or acquisition of an asset intended for business use. It is common for businesses to establish an internal accounting policy, above and beyond GAAP, regarding what purchases and related expenses will be capitalized. This way the business can ensure that the financial statements are not affected in an adverse way. Indiscriminately capitalized costs above what is expected could weigh heavily on future financial results.
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Example
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As an example, the University of California system has capital cost guidelines that require that the asset being bought must be for use by the school rather than for investment or retail. The expected operating life of item must be more than one year. The purchase price of the assets, if basic equipment, must be $5,000 or more, or $35,000 or greater if it's a major repair, building or infrastructure improvement.
Costs that can be Capitalized
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While not an all-inclusive list, some costs that should be considered for capitalization would be purchase price, appraisals, professional services, title insurance, associated fees, closing costs, shipping and handling, installation, duties and site improvements.
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References
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