Capitalization policy definition
/What is Capitalization Policy?
A capitalization policy is used by a company to set a threshold, above which qualifying expenditures are recorded as fixed assets, and below which they are charged to expense as incurred. The policy is typically set by senior management or even the board of directors.
Some elements of a capitalization policy may be driven by common practice within an industry. If competitors capitalize their assets in a certain manner, a business may want to follow suit, in order to provide financial statements to the investment community that are comparable to those issued by competitors.
The capitalization policy also governs whether certain expenditures are accounted for as separate assets, or as part of a larger asset. For example, the policy could state that the roof of a building be classified separately from the rest of the structure, on the grounds that the roof may be replaced several times over the life of the building.
Another criterion for separate classification as a fixed asset is when an item has significantly different maintenance requirements from those of nearby assets. Thus, the capitalization policy could state that a group of machines clustered on an assembly line be classified as a single asset if they share common maintenance requirements, but as separate assets if they have significantly different maintenance requirements.
The policy may also state the circumstances under which leased assets are to be recorded as fixed assets, as well as the circumstances under which interest costs are to be capitalized into the fixed assets with which they are associated. The requirements for doing so are stated under Generally Accepted Accounting Principles and International Financial Reporting Standards.
What is a Good Capitalization Limit?
The threshold level set by a capitalization policy can vary considerably. A smaller business with few expenditures may be willing to accept a low capitalization threshold of just $1,000, whereas a larger business that may be overwhelmed by the recordation requirements of fixed assets may prefer a very high limit, such as $50,000. Nonprofits may prefer a low capitalization limit, so that they can keep close track of their assets. Many businesses find that a capitalization threshold of about $5,000 balances the offsetting issues of avoiding excessive record keeping and avoiding charging large items to expense as incurred.
Is the Capitalization Limit Covered by GAAP?
The Generally Accepted Accounting Principles accounting framework does not recommend or require any capitalization limit. There is no mention of it in the framework. Accordingly, when setting a capitalization limit, you should discuss the issue with your outside auditors, to ensure that they are in agreement that your proposed limit is a reasonable one for your business.
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Examples of Capitalization Policies
Here are three examples of capitalization policies used by companies:
Technology equipment capitalization policy. A software company sets a capitalization threshold of $5,000 for technology-related purchases. Under this policy, computers, servers, and networking equipment costing $5,000 or more per unit are capitalized as fixed assets and depreciated over their useful lives, typically 3 to 5 years. Items costing less than $5,000 are expensed immediately. This approach helps manage and track significant investments in rapidly depreciating technology assets.
Building improvement capitalization policy. A real estate management firm adopts a policy to capitalize building improvements that cost $10,000 or more and have a useful life of at least 7 years. For example, installing a new HVAC system for $12,000 would be capitalized and depreciated over its useful life, while minor repairs like painting or plumbing fixes below the threshold are expensed. This policy ensures only substantial enhancements affecting long-term value are capitalized.
R&D equipment capitalization policy. A pharmaceutical company has a policy to capitalize specialized research equipment purchases exceeding $20,000 if they are expected to be used for more than 2 years. For instance, a lab device costing $25,000 would be recorded as a fixed asset and depreciated, whereas smaller tools and short-term supplies are expensed. This policy helps allocate costs accurately to long-term projects and supports financial planning for extensive R&D efforts.
These examples illustrate how different industries tailor capitalization policies to align with their asset management and financial reporting needs.
Capitalization Policy for Non-Profit Entities
A non-profit may have special rules for the recordation of certain fixed assets that are never encountered by for-profit entities, such as donated assets, artwork, and historical treasures. In addition, nonprofits frequently set a relatively low capitalization limit, since this forces them to create records for more assets; this allows them to better track their assets.
When to Set a Low Capitalization Threshold
In some industries, such as non-profits and first responders, it is necessary to keep close track of lower-cost assets, in order to impose a higher level of record keeping than would otherwise be the case. For example, an ambulance company may capitalize oxygen delivery units that would normally be charged to expense, just to have more accurate records of where the units are located.