Capitalising assets: A guide
Capitalising an asset is a fundamental concept in accounting that plays a crucial role in how businesses manage their finances. Understanding when and why to capitalise assets can significantly impact a company's financial statements and overall financial health. In this blog, we’ll explore the purpose of capitalising assets and provide guidance on when to do it.
What does it mean to capitalise an asset
Capitalising an asset means recording it on the balance sheet (sometimes called the statement of financial position) rather than expensing it immediately on the income statement (sometimes called the profit and loss account). This process involves recognising the asset's cost as a long-term investment that will provide benefits over multiple accounting periods. Common examples of capitalised assets include property, computer equipment, and certain intangible assets – including software development in certain scenarios.
For example, if a company purchases computer hardware for £10,000, instead of recognising the entire cost as an expense in the year of purchase, it capitalises the asset and depreciates it over its expected lifespan, say 5 years, reflecting its ongoing contribution to revenue generation over that 5 year period.
Why capitalise assets
- Matching principle: Generally Accepted Accounting Principles state that an expense should be recognised in the same accounting period as the revenue that it helped to earn is recognised. Assets are seen to generate revenue over multiple accounting periods and so capitalising assets aligns with the accounting principle of matching expenses with revenues. This is done by spreading the cost of an asset over its useful life (by way of depreciation or amortisation), meaning businesses can better match the expense with the revenue generated from that asset.
- Improve financial position: Capitalised assets enhance a company's balance sheet by increasing total assets. This can improve financial ratios, such as return on assets (ROA) and debt-to-equity ratio, making the company appear more financially stable to investors and creditors.
- Tax benefits: In some countries, capitalising assets can provide tax advantages. Businesses may be able to depreciate or amortise the asset over time, reducing taxable income in future periods.
When to capitalise assets
Determining when to capitalise an asset involves several considerations:
- Recognition: Capitalisation of property, plant, and equipment is permitted only when future economic benefits are probable and the item's cost is reliably measurable.
- Useful life: An asset should usually be capitalised if it has a useful life extending beyond one accounting period. For instance, machinery purchased for production purposes typically has a useful life of several years, making it a candidate for capitalisation.
- Nature of the asset: Certain types of expenditures are nearly always capital in nature. For example, purchasing land, buildings, or computer equipment – such items are typically capitalised, while routine maintenance costs are usually expensed.
- Improvements vs. repairs: If an expenditure significantly enhances the value or extends the useful life of an asset, it should be capitalised. Conversely, routine repairs that do not improve the asset's value should be expensed.
- Intangible assets: Costs associated with acquiring intangible assets, such as patents or trademarks, should also be capitalised if they provide future economic benefits. Software development costs should also be capitalised if they meet certain criteria.
Can you capitalise VAT on fixed assets
The treatment of VAT on fixed assets depends on the VAT status of the business:
- If the business is VAT registered and can reclaim the VAT, the net cost of the asset (excluding VAT) is capitalised, and the VAT is recorded separately in the VAT account.
- If the business is not VAT registered, the gross cost (including VAT) is capitalised since the VAT cannot be reclaimed.
The above is the position in the UK. If you need advice on the VAT treatment of another country please contact us and we would be happy to help.
How to capitalise an asset
Capitalising an asset involves several steps:
- Determine the cost: Identify all costs associated with acquiring the asset, including purchase price, shipping, installation, and any taxes (excluding recoverable VAT).
- Assess useful life: Estimate the useful life of the asset to determine the appropriate depreciation method.
- Record the asset: Record the asset on the balance sheet. For example: Debit the fixed asset account for the cost. Credit the cash or accounts payable account for the total amount paid.
- Depreciate the asset: Allocate the asset's cost over its useful life through periodic depreciation entries, which will appear as an expense on the income statement.
- Review regularly: Periodically assess the asset for impairment or changes in useful life, adjusting the depreciation schedule as necessary.
Conclusion
Capitalisation of assets is a strategic decision that can have lasting implications for a business's financial health. By understanding the purpose and timing of capitalisation, companies can make informed decisions that align with their financial goals. Whether you're a small business owner or a financial professional, grasping these concepts is essential for effective financial management.
If you have any questions about how to capitalise an asset or need further clarification on specific scenarios, feel free to reach out to us at Tech Relief.
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