Capitalization Rules in Accounting

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Capital expenditure or business expense?
Capital expenditure or business expense? (Image: Hemera Technologies/AbleStock.com/Getty Images)

When you capitalize a cost, you record the amount in the balance statement as an asset instead of recording it as an expense on the income statement. When you do this, the cost becomes an improvement that increases the value of an asset, as opposed to an expense that reduces net income. When deciding whether to capitalize or expense, be sure to conform to the accounting principle of conservatism. If you are not sure whether an expense should be capitalized, you should classify it as an expense.

Capital Improvements to Land

Capital improvements to land should expand the property's usefulness and increase its value. For example, let’s say you build a fence around a parcel of land. You can treat this cost in one of two ways: you can treat it like any ordinary cost by debiting an expense and reducing your net income, or you can debit the cost as an asset and increase the value of the asset. The former treatment will reduce your net income and reduce income taxes. The latter will increase the value of an asset and make the asset worth more upon resale. Building a fence around a parcel of land increases its usefulness as well as its value, and should be capitalized.

Capital Improvements to Buildings

Capital improvements to buildings can include a new roof, new flooring, or a new air conditioner. Expenses such as janitorial services, while keeping the building clean, do not add to the life or efficiency of the building and should not be capitalized. Expenses such as new paint or new carpet in a building also do not sufficiently extend the life of the structure.

Capital Improvement to Equipment

Any expense that prolongs the life or adds to the efficiency of a piece of equipment should be capitalized. Take, for example, copy machines. New toner would not classify as a capital expenditure. Nor would paper to refill the copier be a capital expense. General maintenance would not qualify either. Only expenses that prolong the life or increase the efficiency of the equipment should be capitalized. A repair to the copy machine that includes replacement of the motor or belts would qualify as a capital expenditure, as the life of the copier would be extended.

Capital Improvement to Vehicles

Oil changes and wheel rotations are not capital improvements and should be classified and recorded as routine maintenance. While an oil change does technically extend the life of a vehicle, it does not improve the efficiency or quality of the vehicle. Capital improvements to a vehicle would include a new engine or transmission, as this would extend the useful life of the vehicle.

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References

  • "Financial & Managerial Accounting, 2nd Ed."; Charles T. Horngren et al.; 2009
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