Anthony McVeigh •
A common struggle many face is knowing when they should capitalize a cost or expense it. I am here to help! The rule of thumb for determining what should be capitalized is how long the item will be useful to you. If the item is expected to provide short-term benefits (less than a year) such as inventory, then it must be expensed in the period incurred. You capitalize an item when you expect it to provide you with long term benefits (greater than one year). In this case you capitalize and depreciate or amortize over the useful life of the asset.
A common struggle many face is knowing when they should capitalize a cost or expense it. I am here to help! The rule of thumb for determining what should be capitalized is how long the item will be useful to you. If the item is expected to provide short-term benefits (less than a year) such as inventory, then it must be expensed in the period incurred. You capitalize an item when you expect it to provide you with long term benefits (greater than one year). In this case you capitalize and depreciate or amortize over the useful life of the asset.
The useful life of an asset is important in determining whether you capitalize a cost and how long to depreciate it. Also consider whether your company has a capitalization policy, so that anything under a certain amount isn’t capitalized. In most cases the IRS allows for capitalization thresholds of $2,500. To determine the useful life, a few things to consider are the manufacturer specifications, past history of similar assets, or past experience with that particular item. A good rule of thumb is 5 years for vehicles, 5-7 years for equipment, 35-40 years for buildings and improvements, and 5-10 years for furniture and equipment.
An easy way to get more clarity on how to determine the useful life of assets, is by visiting the IRS Publication 946, Appendix B, which lists the useful life estimates by industry and application. These estimates can be used as a baseline for the useful life of your assets.
After determining if the item is an expense or should be capitalized, you need to record it on your books. If it is an expense you recognize it as an expense on the income statement, in the same period as when the expense was incurred. If you capitalized the cost, then you recognize it on the balance sheet as a fixed asset, and the asset is reduced by depreciation or amortization annually; depreciation and amortization are an expense on the income statement.
The purpose of capitalizing an item is to match the timing of the benefits with the costs. Depending on the type of asset it will be either depreciated or amortized over the life of the asset. Property, Plant & Equipment (PP&E) are depreciated and intangible assets are amortized. PP&E are assets that have physical form that you are able to see. Intangible assets are not physical in nature, such as a patent, brand, trademark, or copyright.
An example of PP&E is a building. This is a long-term asset that will provide benefits for more than one year. One of the US Generally Accepted Accounting Principles (GAAP) primary goals is to match revenue with expenses, so recording the expense all at once would inaccurately reflect the financial position of a company. If you buy a building for $5,000,000 and expect the useful life to be 40 years, then the depreciation expense would be $125,000. Assuming there is no salvage value at the end of 40 years, the initial $5,000,000 carrying value of the PP&E would decline by $125,000 each year for the next 40 years until there is no balance.
For example let’s say you have purchased $3,000 worth of paper that will be used to print tax returns. This is over the $2,500 capitalization policy so should it be capitalized? The answer is no because the paper is used too quickly and does not provide a long term benefit to the company. The benefits are short-term and should be expensed in the period they occur.
We understand this can be confusing and may not always be a clear answer as to what you should capitalize. If you need further help contact your accountant to get more advice!
An easy way to get more clarity on how to determine the useful life of assets, is by visiting the IRS Publication 946, Appendix B, which lists the useful life estimates by industry and application. These estimates can be used as a baseline for the useful life of your assets.
After determining if the item is an expense or should be capitalized, you need to record it on your books. If it is an expense you recognize it as an expense on the income statement, in the same period as when the expense was incurred. If you capitalized the cost, then you recognize it on the balance sheet as a fixed asset, and the asset is reduced by depreciation or amortization annually; depreciation and amortization are an expense on the income statement.
The purpose of capitalizing an item is to match the timing of the benefits with the costs. Depending on the type of asset it will be either depreciated or amortized over the life of the asset. Property, Plant & Equipment (PP&E) are depreciated and intangible assets are amortized. PP&E are assets that have physical form that you are able to see. Intangible assets are not physical in nature, such as a patent, brand, trademark, or copyright.
An example of PP&E is a building. This is a long-term asset that will provide benefits for more than one year. One of the US Generally Accepted Accounting Principles (GAAP) primary goals is to match revenue with expenses, so recording the expense all at once would inaccurately reflect the financial position of a company. If you buy a building for $5,000,000 and expect the useful life to be 40 years, then the depreciation expense would be $125,000. Assuming there is no salvage value at the end of 40 years, the initial $5,000,000 carrying value of the PP&E would decline by $125,000 each year for the next 40 years until there is no balance.
For example let’s say you have purchased $3,000 worth of paper that will be used to print tax returns. This is over the $2,500 capitalization policy so should it be capitalized? The answer is no because the paper is used too quickly and does not provide a long term benefit to the company. The benefits are short-term and should be expensed in the period they occur.
We understand this can be confusing and may not always be a clear answer as to what you should capitalize. If you need further help contact your accountant to get more advice!
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