What is the Capitalization Limit?

The capitalization limit is the amount paid for an asset, above which an entity records it as a long-term asset. If an entity pays less than the capitalization limit for an asset, it charges the asset to expense in the period incurred. This limit is imposed in order to reduce the record keeping associated with long-term assets.

Example of the Capitalization Limit

Muldrow Corporation has a board-imposed capitalization limit of $2,500, where all expenditures on long-term assets of $2,500 or more must be capitalized. The company purchases a laptop computer for $1,900 and charges it to expense at once, since the laptop cost less than the capitalization limit. The company also purchases production machinery that cost $20,000; it capitalizes this amount, since it exceeds the capitalization limit and the machinery will be used for many years.

How to Set a Capitalization Limit

There are advantages and disadvantages associated with setting either a high or low capitalization limit, which are as follows:

Advantages of a Low Capitalization Limit

Comprehensive asset tracking. A low capitalization limit captures more assets on the balance sheet, providing a detailed view of the organization's property and equipment. This can aid in asset management and loss prevention.
Delays expense recognition. A low capitalization limit results in more costs being depreciated over time, leading to smoother expense recognition rather than a single-year hit to the income statement. This may align better with the matching principle in accounting, where expenses are recognized in the period they contribute to revenue.
Better financial control. A lower threshold can ensure that expenditures on small items are scrutinized before purchase. This reduces the likelihood of overspending on frequently replaced items by increasing accountability for their acquisition and management.

Disadvantages of a Low Capitalization Limit

Increased administrative burden. A low capitalization threshold increases the volume of capitalized assets, requiring more detailed tracking, accounting entries, and periodic reviews (e.g., physical inventories).
More complex financial reporting. A low capitalization threshold inflates the balance sheet with many small assets, potentially cluttering financial statements and complicating decision-making. This may obscure the distinction between significant long-term investments and minor expenditures.
Risk of inconsistency. The lower the limit, the greater the risk of inconsistencies in capitalization decisions, particularly if there’s ambiguity about what qualifies as an asset (e.g., components, group purchases). This could lead to disputes during audits if items are misclassified.
Reduces immediate expense recognition. A lower threshold defers more costs to future periods, which may not always be desirable for organizations wanting to recognize expenses upfront (e.g., for tax purposes or to avoid over-inflating earnings).

Advantages of a High Capitalization Limit

Simplified accounting process. A high capitalization threshold means that fewer items need to be tracked and depreciated over time, reducing administrative burdens. This saves time and costs in record-keeping and compliance efforts.
Reduced audit complexity. Auditors have fewer assets to assess for impairment, depreciation, and compliance with accounting standards. This may reduce the cost of the audit.

Disadvantages of a High Capitalization Limit

Possible under-reporting of assets. Small but frequent expenditures might aggregate to a significant value, and expensing them immediately could understate total assets on the balance sheet.
Distorts profitability metrics. Expensing higher amounts upfront (instead of spreading them over time through depreciation) could reduce net income in the short term, potentially misrepresenting profitability.
Risk of non-compliance. Setting a limit too high might conflict with industry standards, regulatory requirements, or tax laws, leading to penalties or disputes during audits.
Reduces reported earnings. Expensing larger items immediately impacts the current period's expenses, which may lead to a significant reduction in reported earnings.