In the world of business, access to capital can determine your success or failure. Capital is cash and other assets. There are two different types of assets -- those that are capitalized and those that are expensed. The difference is created due to taxes. Capitalized assets are written off over the life of the asset whereas all other assets are expensed in the year they were purchased.
In order for an asset to be considered capitalized, it must be able to generate revenues for more than one year. That is, it must have a useful life greater than one year. For instance, most office supplies are expensed in the year they are purchased. This is because they are used in the current year. Plant, property and equipment is usually capitalized since it is used for a period greater than one year.
It is important to understand why this is accounting convention before discussing the affect on taxes. Accounting convention states that expenses should be incurred and matched to the revenues they create. So if equipment is purchased that has a useful life of five years, it must be expensed over five years. Expensing the entire cost of the equipment in one year does not take four years of revenue generation into consideration.
From a tax perspective, businesses want to report a lower net income in order to owe fewer taxes. As a result, they are always looking for tax deductions or ways to adjust net income downward. Depreciation is the name given to the portion of the capitalized asset that is expensed. Depreciation lowers net income, which lowers the tax provision.
Ultimately, the only difference between a capital asset and an expensed asset is that one provides value into the future. It also helps to maintain accounting integrity and to revalue assets over time.