Capitalization is a bookkeeping or accounting technique wherein an expense or cost of an asset is recorded in a permanent account and expensed over the useful life of that asset instead of being expensed in the same period the expense initially took place.
You may also understand it as a process of taking an expense (that would generally be recorded in a temporary account) and recording it in a permanent account like an asset account. It is the recordation of an expense or cost as an asset rather than an expense or cost. It is utilized when an expense isn’t supposed to be completely consumed in the current period, but instead throughout an extended timeframe.
What is Capitalization?
Definition: Capitalization is defined as an accounting rule used for perceiving an expense or cost or cash outlay as an asset on the balance sheet instead of as an expense on the income statement.
When it comes to the world of finance, the same capitalization is understood as the quantitative evaluation of the capital structure of a firm. Here it alludes to the expense or cost of capital as a corporation’s stock, retained earnings, and long-term debt.
Hence, capitalization has different implications and meanings. In the world of accounting, it alludes to the most common way of expensing the costs of acquiring an asset over the existence or useful life of the asset instead of the period the expense took place. Due to this, the expense is not listed as an expense and it gets added to the balance sheet of the company and devalued over its valuable life.
While in finance, the concept of capitalization alludes to the sum of the stock of a corporation, retained earnings, and long-term debt. Capitalization in finance also refers to the quantity of a corporation’s outstanding stocks multiplied by the share price of the stock. This is likewise understood as market capitalization.
During the accounting process, most of the incomes or revenues and expenses or costs are recorded during the time they incur.
But companies might get some benefits by expensing specific assets for more than one accounting period. This generally happens with some of the large assets that might be expenses of a 20-to 30-year time span.
Another term for capitalization in the finance field is book value. At the point when investors talk about the book value of a company, they will be alluding to the sum of the stock of the company, retained earnings, and long-term debt.
For deciding the market capitalization of a company, you should multiply the outstanding stocks of the company by its share price.
Companies having market capitalization between $300 million and $2 billion are named small-cap companies while companies with a market capitalization between $2 billion and $10 billion are viewed as mid-cap companies.
Finally, those companies that have $10+ billion market capitalization are viewed as large-cap companies.
Importance of Capitalization
Capitalization is used in accounting to perceive an expense or cash outlay as an asset on the accounting report or balance sheet. It also helps through quantitative evaluation of the capital structure of a firm.
Hence, capitalization in accounting takes into consideration an asset that is supposed to be devalued over its valuable life showing up on the balance sheet instead of the income statement. While in finance, it talks about the book value or the total of the debt and equity of a company.
Market capitalization can be understood as the dollar value of outstanding shares of a company and is determined as the current market price increased by the total number of outstanding offers.
On the other hand, capitalization might be incredibly unusual in the service industry, particularly when the cap limit is set sufficiently high to stay away from the recordation of laptops and PCs as fixed assets.
Types of Capitalizations
The matching principle of accounting expects companies to record costs in a similar bookkeeping or accounting period in which the related revenue or income took place.
To understand it better, let us consider the example of office supplies that are usually expensed in the period when they are brought, as they are supposed to be consumed within a shorter timeframe.
But, some of the bigger office tools might be useful to the business over more than one bookkeeping or accounting period. These items include a variety of fixed assets, like PCs, vehicles, and buildings of business. The expenses of these sorts of items are recorded on the general ledger as the asset’s historical cost. Hence, these expenses are supposed to be capitalized, and not expensed.
These capitalized assets are not expensed in full against earnings in the current accounting or bookkeeping period. You might make a huge buy however expense it over many years as per the involved PPE.
Such assets are spent over a longer time period to produce income for the company, a piece of the expense or cost is assigned to each bookkeeping or accounting period which is known as depreciation or amortization of intangible assets.
When it comes to the leased equipment, capitalization can be understood as the conversion of an operating lease to a capital lease by classifying the leased asset as a purchased asset that will be included in the balance sheet as a component of the assets of a company.
The FASB or Financial Accounting Standards Board came up with a new ASU or Accounting Standards Update that requires all leases over the period of a year to be both capitalized as an asset and recorded as a liability on the books of the lessee to genuinely introduce both the obligations and rights of the lease.
The next type of capitalization is associated with the capital structure of a company. It can allude to the book value cost of capital that is the amount of the long-term debt, retained earnings, and stock of the company. Here another option to the book value is the market value. You need to understand here that the market value cost of capital relies upon the cost of the stock of the company. It is determined by multiplying the company’s share price by the number of shares outstanding in the market.
Companies having a high market capitalization are understood as the large caps. Another thing to notice here is that a company may be overcapitalized or undercapitalized. During the process of undercapitalization, earnings or incomes are not considered enough for covering the cost of capital like dividend payments to shareholders or interest payments to bondholders. While on the other hand, overcapitalization takes place when there’s no requirement for outside capital since profits are high and earnings or income were misjudged and undervalued.
Capitalization of Interest Costs
In the event that a company builds fixed assets, borrowed funds’ interest cost used to pay for the construction can likewise be capitalized and recorded as a component of the hidden fixed assets. The use of this step comes into play for significant construction projects.
The “capitalization” is likewise associated with the market value of a business. It is determined as the total number of shares outstanding multiplied by the current market prices of the stock.
It can likewise be characterized as the sum of the stock of a company, long-term debt, and retained earnings.
What Does Capitalization Mean in Accounting?
Capitalization is a bookkeeping or accounting rule useful in perceiving a cash outlay as an asset on the balance sheet instead of as an expense on the income statement.
How Does Capitalization Impact Lease Equipment?
For the leased equipment, you may understand capitalization as the conversion of an operating lease to a capital lease by considering the leased assets as purchased assets that are also included on the balance sheet as part of the assets of the company.
What Does Capitalization Mean in Finance?
Capitalization in finance is understood as a quantitative assessment of the capital structure of a firm. It refers to the book value cost of capital that you can understand as the sum of the long-term debt of a company, retained earnings and stock, and retained earnings. Book value’s alternative is understood as market capitalization or market value.
Overall, it may be said that capitalization takes place when you record expense or cost in a permanent account and systematically allocate it over future periods.
It considers an expense and records it as a permanent account like an asset account. To briefly paraphrase, how would you define capitalization in your words?