When you purchase assets for your business, such as real property, machinery, vehicles and equipment, you may have the option of capitalizing or expensing the asset. When you expense an asset, you pay for the item and include its total cost as an expense on your income statement. When you capitalize the asset, you list its value and any debts associated with acquiring it on your balance sheet. With capitalization, the cost you incur for purchasing the item is recovered over time versus immediate recovery under the expense method.
1. Determine the book value of the asset you wish to capitalize. In general, the book value of the asset equals the invoice price you paid or financed to acquire the property.
2. List the value of the property as a long-term asset on your balance sheet.
3. Create a long-term liability account on your balance sheet for the principal amount of any debt, such as a loan, lease-to-purchase agreement or other credit term you owe for the property. Name the account “Notes Payable.”
4. Create an “interest payable” long-term liability account on your balance sheet. The beginning balance for this account equals the amount of interest you owe on any financing you obtained to purchase the capitalized asset.
5. Create an interest expense account for your income statement.
6. Reduce your "notes payable" balance sheet account each time you make a principal loan payment on the asset.
7. Reduce your "interest payable" balance sheet account each time you make an interest payment on the note.
8. Record interest expense paid on your income statement during the period that you paid the interest. Do not record note payments on your income statement. At the end of the year, calculate the depreciation expense for the asset and record the amount on your income statement. Capitalized assets use the depreciation method to recover the principal cost of the asset over a period of time.