When a company purchases a capital asset, it can expense or capitalize the cost and expenses related to the asset. A long-term asset is typically an asset that has a useful life of one year or more. The costs related to an asset typically include purchase price and construction, assembly or financing cost.
Capitalization versus Expensing
When a company expenses the costs of an asset, it deducts the total cost to acquire the asset in the current accounting period. Doing so typically results in a dramatic decrease in net income reported on the income statement for that period. This decrease makes the company appear less financially stable than it truly is. Capitalizing the asset over its useful or economic life helps to prevent dramatic increases and decreases in net income reported on the income statement and gives a more accurate picture of the financial stability of a company.
When utilizing capitalization, the company adds all of the expenses associated with the asset into its total cost. It then deducts a portion of the total cost of the asset over a period of time, usually its useful or economic life. An asset's useful life is how long the company can reasonably expect to use the asset before it is sold, becomes obsolete or falls into a state of disrepair. The economic life is how long the company can reasonably expect the asset to contribute to the company’s revenue generating activities. Depreciation, amortization and depletion are the methods companies use in asset capitalization.
Only the depreciation expense related to the asset is reported on the company’s income statement. For example, if a company purchases a piece of equipment with a useful life of 10 years, for a total cost of $10,000, it depreciates the equipment by $1,000 per year, assuming straight-line depreciation. The $1,000 depreciation expense assigned to the equipment appears on the income statement. The $10,000 purchase price less the amount of the equipment’s accumulated depreciation appears on the balance sheet.
When a company capitalizes the total cost of the asset, it reduces the degree to which the reported net income on the income statement varies from one accounting period to the next. This occurs because the company deducts the capitalized costs of the asset equally in each accounting period. The capitalization of assets often results in more consistent net income amounts reported on the income statement from one accounting period to the next.
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