Should you capitalize or expense your business’ or organization’s latest purchase?
This is a question that should be getting answered for each and every purchase you make. The answer you decide will have an effect on the usefulness of your financial statements, the size of your record-keeping burden, and how much you pay in taxes.
The point of capitalization
Making this decision requires you to understand what the point of capitalization is. To this end, I’d like you to perform a quick mental exercise. Think about the items you have at your residence. You probably have things ranging from appliances to snacks, medicines to tools. Now think about the cost of these items and how long they may provide you value. For example, the refrigerator you use continually over the course of many years; as long as it runs, it provides value. The point of capitalization is to allow you to state in a quantitative fashion what exactly that value is and to account for expenses related to that value over time.
How capitalization works
How capitalization works is that when you make a purchase, you record what you bought as an asset on your balance sheet at the price you paid. You then take depreciation expense on your income statement over time to represent the cost of the asset over its useful life.
Using the refrigerator example, suppose you paid $3,000 for it and you expect it to run until the manufacturer’s warranty expires in 5 years. Each year you would record the accumulation of a certain amount of depreciation, which when subtracted from the original value of your refrigerator would tell you what it is currently worth.
How much depreciation occurs each year can be determined using several calculation methods, each with their own logic and uses. You may have heard terms such as straight-line, MACRS, or Section 179. What do they all mean and how do you decide which method to use? A multitude of factors play into this decision, such as your organization’s entity structure, accounting method and the category of asset. Consulting with someone who is knowledgeable about such matters is always recommended, like one of the many experienced professionals at Wegner CPAs.
Of course, there is a record-keeping burden associated with tracking an asset’s value, which is why you may not always want to do so. For example, an apple in your fridge is not going to be there for very long. It would be an unwise use of time to record the apple as an asset and then create a detailed record of its slightly declining value before said value is completely used up on account of it being eaten. Furthermore, even if you did have an item inside your fridge that was going to be there for a while, such as the fridge’s light bulb, the starting value would barely be a dollar and the depreciation you would be recording over the life of such a low-value item would not even reach a dollar per year. You will not need to know how much value the light bulb in your fridge currently still has when the difference in value of a brand-new, one and two-year old lightbulb is pennies. In these types of scenarios, it would not make sense to capitalize the item and you would instead expense it, which means recording it immediately as an expense on your income statement when the item is purchased.
What defines a low-value item, what is the cut-off for the time-period wherein it is no longer worthwhile to track an item’s declining value, what if you buy a large number of low-value items and what about items that can be sold for parts well after their useful lives? Those are excellent questions whose answers will vary significantly depending on the item, so again it would be best to seek guidance from someone who is not only knowledgeable on such matter themselves, but who can also collaborate closely with other experts to ensure you receive only the highest quality answers. Such individuals are found right here at Wegner CPAs and they would be happy to help you craft a capitalization policy to ensure that you are capitalize wise!
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