Capitalization and Amortization

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Whenever a company purchases an asset with long term value, it must be capitalized. Every asset that is capitalized is then depreciated, which is special form of amortization. 

Quick reference

Capitalization and Amortization

Capitalization is the process by which something that is purchased (usually land, buildings, or equipment) becomes a fixed asset on the Balance Sheet.   Amortization is the write-down of an account balance on the Balance Sheet.

When to Use Capitalization and Amortization

Whenever a company purchases an asset with long term value, it must be capitalized.  Every asset that is capitalized is then depreciated, which is special form of amortization.  Amortization also applies to intangible asset accounts.

Instructions

  • The business must first decide to acquire an asset – this is normally done through purchasing land, buildings or equipment.  However it can also include the development of an internal system in certain special cases.
    • When a fixed asset is modified or improved, such as putting an addition on a building, that modification can also be capitalized.
  • When the asset is identified, finance will capitalize it on the business books.
    • It is listed as a fixed asset on the Balance Sheet.
    • The purchase is recorded as an Investment Cash Flow on the Cash Flow Statement.
    • When an asset is capitalized, the purchase IS NOT included on the Earnings Statement for the period in which it was purchased.
  • If the company pays cash, the cash account is decreased.  If money is borrowed to pay for the asset, the debt is increased, the value of the loan is placed in cash and then the cash account is decreased to pay for the asset.
  • There are special accounting rules that determine the minimum purchase price for assets in different technical categories.  If the price is less than the minimum, the asset is treated like a normal expense and it is not capitalized. 
  • Finance tracks capital expenses closely because of their impact on financial statements and because the business must pay property taxes on fixed assets.
  • Since amortization applies to intangible asset and financial accounts, operating managers and project managers seldom have anything to do with amortization. 

Hints and Tips

  • If you are not certain whether to capitalize something, check with finance.  There are numerous accounting standards and tax laws that apply – and these change often.  Finance is the expert in this area, they will be able to answer your question.
  • Generally businesses want to capitalize as much as they can because money spent on capitalized assets does not show as an expense in the current year and therefore will have a tendency to create a higher Net Income in the current year.
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  • 00:01 Hi, I'm Ray Sheen.
  • 00:05 I'd like to talk with you about some of the more complex and
  • 00:08 often confusing topics in financial planning and accounting and
  • 00:12 that's capitalization and amortization.
  • 00:15 Let's get started.
  • 00:17 Capitalization and amortization are companion processes used by
  • 00:20 the finance community when working with assets.
  • 00:23 Capitalization is focused on how we record the assets in the companies financial
  • 00:26 books and amortization is the process used for recording the payment for that asset.
  • 00:31 Let's start with capitalization.
  • 00:33 Whenever a company buys or builds something
  • 00:36 it must be treated as either an expense or an asset on the company's books.
  • 00:41 Items that were bought or built and
  • 00:42 are perceived to have a long-term value are normally capitalized.
  • 00:46 Which means they are treated as an asset, not an expense,
  • 00:49 on the company's financial records.
  • 00:51 So to capitalize something means to treat it as a fixed, or capital, asset.
  • 00:56 That carries a number of implications, not the least of which is the impact on taxes.
  • 01:00 There are special accounting rules on how the cost of a capital asset is recorded.
  • 01:05 By the way,
  • 01:05 there are thresholds on what an item must cost before it can be capitalized.
  • 01:09 These thresholds vary based upon the type of asset and
  • 01:12 the accounting rules in place.
  • 01:13 So check with your finance person to find out the current limits for your operation.
  • 01:18 From an operating manager or project manager's perspective, assume that any
  • 01:22 equipment or facility modification that you pay for will be capitalized.
  • 01:27 If it is capitalized, it must be amortized.
  • 01:29 Let's switch over to amortization.
  • 01:32 The financial definition of amortization is that it is the process used for
  • 01:36 reducing the value of an account.
  • 01:38 You can think of this in the context of a house or car loan.
  • 01:41 As you are paying the loan, the outstanding balance is shrinking.
  • 01:44 Amortization can be applied to many different types of accounts.
  • 01:48 As an operating manager, we typically think of amortizing intangible assets
  • 01:53 such as intellectual property.
  • 01:55 When an account is subject to amortization, an amortization schedule is
  • 01:59 created that shows how much the account will be written down, or
  • 02:02 reduced, in each time period.
  • 02:04 Once established that amortization's schedule for
  • 02:07 assets cannot be easily changed.
  • 02:09 The amortization schedule of debt normally shows how much principal reduction and
  • 02:14 interest will occur in each time period.
  • 02:17 For intangible assets, the amortization schedule shows how the value of that asset
  • 02:21 reduces in each time period.
  • 02:24 On the earning statement,
  • 02:25 that amortization amount is treated as an operating or overhead expense.
  • 02:29 It represents the value of the asset that is been used up or
  • 02:32 consumed during that time period.
  • 02:35 We will talk in another module about amortization of fixed assets.
  • 02:39 This special case of amortization is called depreciation and
  • 02:42 there are special accounting and tax rules that are associated with it also.
  • 02:47 Let's discuss the impact of capitalization on our financial reports.
  • 02:50 I will discuss the amortization impacts when I review depreciation
  • 02:54 in another module.
  • 02:56 When asset is bought or built it must be capitalized.
  • 02:59 There is no impact on the earning statement when an asset is capitalized.
  • 03:02 It is as though the transaction never happened.
  • 03:05 On the balance sheet the value of the asset is added to fixed assets but
  • 03:09 the balance sheet must be balanced.
  • 03:11 So if the company agrees to pay cash that will balance
  • 03:14 everything since a current asset offsets the value of the fixed asset.
  • 03:18 Depending upon how fast they pay, the asset value may be in accounts payable for
  • 03:23 a short time but when the cash is paid, the accounts payable is reduced.
  • 03:27 The other option is for the company to borrow money to pay for
  • 03:29 the asset, which increases debt in the liability category.
  • 03:33 The cash flow statement shows the use of cash as an investing activity and
  • 03:38 that will lower the cash balance.
  • 03:40 If the company borrowed money to pay for the asset that would've been
  • 03:43 an increase in cash in the financing activity category.
  • 03:46 As I have mentioned, there's special accounting and
  • 03:48 tax rules that apply to assets in capitalization.
  • 03:51 The finance department has people whose job is to know those.
  • 03:54 Seek their advice when capitalizing buildings or equipment.
  • 03:59 Now you may have had trouble following the impact of the financial reports that I
  • 04:02 just covered, so let me illustrate them for you.
  • 04:04 First nothing happens on the earning statement.
  • 04:07 Its like it never happened.
  • 04:10 On the balance sheet the fixed assets go up when we capitalize something.
  • 04:14 But we must balance the balance sheet so either we pay for
  • 04:17 it with cash or we borrow money to pay for the asset and increase the debt.
  • 04:22 On the Cash Flow Statement, we have a use of cash to purchase the asset which is
  • 04:27 recorded as an investing activity and this results in a reduction to free cash flow.
  • 04:32 So let's wrap up.
  • 04:35 Capitalization is how we make something a fixed asset.
  • 04:38 It has special reporting and tracking requirements.
  • 04:41 Amortization is the slow write down of an account.

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