What you need to know about capitalization and depreciation of business assets

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Read time: 4:30 minutes (810 words) 

As a business owner, your hands are full of the everyday responsibilities of running a business, from planning and budgeting to hiring, marketing, sales, operations, payroll and more. Working with a trusted advisor every step of the way can help alleviate the stress that comes with back-office work. Because let’s face it, that’s probably not where the passion for starting your business came from. We’re guessing you’d much rather be out front with your customers. 

Even so, it’s essential that you have a good grasp on the financial health of your business. And one of the best ways to accomplish this is to communicate regularly with your accountant to ensure you understand your financial statements, tax obligations and compliance requirements.  

Every business owner needs to understand asset management and the concepts of capitalizing and depreciating assets. Familiarity with these accounting methods will help ensure accurate financial reporting and tax calculations...and contribute to your overall financial strategy. 

Let’s explore the terms and the criteria for when an asset should be capitalized and depreciated. And then, we’ll look at a practical example of how it works. 

What is asset capitalization? 

Capitalization is when you record a cost or expense on the balance sheet to delay full recognition of the expense. In other words, when a business acquires an asset that will benefit the company beyond the current tax year, it is capitalized. This means the cost of the asset is spread out over its useful life, rather than being expensed entirely in the initial period in which it was purchased. 

Examples of capitalized assets: 

  • Buildings 

  • Equipment 

  • Vehicles 

  • Machinery 

  • Furniture 

What is asset depreciation? 

Depreciation is when you allocate the cost of a tangible asset over its useful life to reflect its wear and tear and deterioration. It allows businesses to spread out the cost of the asset and match the expense of using the asset (part of the asset’s cost) with the revenue it generates for each year, thereby adhering to the matching principle in accounting. Depreciation can provide substantial tax deductions over the life of an asset and give a more accurate picture of a business’s financial health. 

Common methods of depreciation include: 

  • Straight-line depreciation: Spreads the cost evenly across the asset’s useful life. 

  • Accelerated depreciation: Includes methods like double-declining balance and sum-of-the-year’s digits, which allocate higher depreciation costs in the earlier years of the asset’s life. 

How it works (and a real-life example) 

Here’s how the process works. An asset is capitalized when it is purchased. This means its cost is recorded on the balance sheet as an asset rather than an expense. After capitalization, if the asset has a limited useful life and will lose value over time, it is depreciated. This depreciation is then recorded periodically as an expense on the income statement. 

Let’s say your business purchases a new building at the cost of $1 million. Here’s what would happen: The purchase price of the building is capitalized. The total cost is recorded on the balance sheet as a long-term asset under “Property, Plant and Equipment (PP&E).” You decide to use the straight-line depreciation method for the building, and you determine the building has an estimated useful life of 40 years. The annual depreciation expense is $25,000 ($1 million/40 years). Each year, $25,000 is recognized as a depreciation expense on the income statement, reducing the net book value of the building on the balance sheet. 

Now, let’s say your company also needs new office furniture for the new building. So, you purchase new office furniture totaling $50,000, and the total cost is capitalized. The cost is recorded as a long-term asset under “Furniture and Fixtures” on the balance sheet. Again, you decide to use the straight-line depreciation method for the office furniture, which you determine has an estimated useful life of 10 years. The annual depreciation expense is $5,000 ($50,000/10 years). Each year, $5,000 is recognized as a depreciation expense on the income statement, reducing the net book value of the furniture on the balance sheet. 

By capitalizing the cost of both and depreciating these assets over their respective useful lives, you accurately match expenses with the revenue they helped generate. This ensures compliance with accounting principles and provides a true representation of your business’s financial health. 

Consult a professional 

Making the decision to capitalize the purchase of a business asset can significantly impact your company’s financial statements and tax liabilities. As a small business owner, you have a lot to worry about, but it’s imperative to understand how asset management works and consider asset type, cost and expected useful life when looking at new purchases for your business. To ensure the proper treatment, you’ll want to consult with your accountant to handle the details of asset capitalization and depreciation to keep your business in good standing.