Capitalization limit definition

What is a Capitalization Limit?

A capitalization limit ("cap limit") is the threshold above which an entity capitalizes purchased or constructed assets. Below the cap limit, you generally charge purchases to expense instead. There is no specifically required cap limit; a business should consider a number of factors before settling upon the most appropriate limit. If the cap limit is extremely low, some expenditures will be shifted into fixed assets that would normally have been charged off at once, which will make short-term profits look somewhat higher. On the other hand, these items will still be charged to expense eventually, so a low cap limit increases the depreciation expense in later years. If you set a high cap limit, there will be substantially fewer assets to record in the fixed assets register, which can reduce the workload of the accounting staff. However, if you set too high a cap limit, a larger number of big-ticket purchases will be charged to expense in the current period, which tends to make month-to-month profits vary more than operating results would normally indicate.

Setting a low cap limit will also create a larger fixed assets register on which the local government jurisdiction will be more than happy to charge personal property taxes, whereas an excessively high cap limit will yield so few reportable assets that it may trigger a time-consuming government tax audit.

Thus, there is no perfect answer. From an efficiency perspective, it is better to have fewer fixed asset records to keep track of, so I prefer a relatively high cap limit. If management wants to impose a really low cap limit in order to bolster short-term profits, explain to them that this will result in more short-term income taxes, as well as more personal property taxes, potentially for years to come; these changes result in a cash outflow in the form of tax payments that would not have been present if a higher cap limit had been used.

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How to Capitalize Assets

A business may make a number of expenditures every year that call for a decision regarding whether they should be capitalized, so you should have a process in place for deciding whether to do so. The following steps are key to the process:

  1. Determine the full cost of the expenditure. This includes any related sales taxes, import fees, transport fees, and other fees required to bring the related item to the position and operating condition for which it is intended to be used.

  2. Determine whether the item will provide value to the organization for at least one year from the installation date.

  3. If the total cost exceeds the organization’s capitalization limit and it will be used for at least one year, then recognize it as a fixed asset. Otherwise, charge it to expense in the period when the cost was incurred.

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