Capitalization: What It Means in Accounting and Finance

What Is Capitalization?

Capitalization is an accounting method in which a cost is included in the value of an asset and expensed over the useful life of that asset, rather than being expensed in the period the cost was originally incurred. In addition to this usage, market capitalization refers to the number of outstanding shares multiplied by the share price, which is a measure of the total market value of a company.

Key Takeaways

In accounting, capitalization allows for an asset to be depreciated over its useful life—appearing on the balance sheet rather than the income statement.
Assets are capitalized to record the expense over time to match the period when benefit is received to when costs are recognized.
In finance, capitalization refers to the book value or the total of a company's debt and equity.
Companies that are undercapitalized mean the company does not have enough capital on hand to finance all obligations.
Market capitalization is the dollar value of a company's outstanding shares and is calculated as the current market price multiplied by the total number of outstanding shares.

Understanding Capitalization

In accounting, capitalization is an accounting rule used to recognize a cash outlay as an asset on the balance sheet rather than an expense on the income statement. In finance, capitalization is a quantitative assessment of a firm's capital structure. Here it refers to the cost of capital in the form of a corporation's stock, long-term debt, and retained earnings.

Types of Capitalization

There are two key types of capitalizations, one of which is applied in accounting and the other in finance.

Accounting

In accounting, the matching principle requires companies to record expenses in the same accounting period in which the related revenue is incurred. For example, office supplies are generally expensed in the period when they are incurred since they are expected to be consumed within a short period of time. However, some larger office equipment may provide a benefit to the business over more than one accounting period.

These items are fixed assets, such as computers, cars, and office buildings. The costs of these items are recorded on the general ledger as the historical cost of the asset. Therefore, these costs are said to be capitalized, not expensed. Capitalized assets are not expensed in full against earnings in the current accounting period. A company can make a large purchase but expense it over many years, depending on the type of property, plant, or equipment involved.

As the assets are used up over time to generate revenue for the company, a portion of the cost is allocated to each accounting period. This process is known as depreciation (or amortization for intangible assets). For leased equipment, capitalization is the conversion of an operating lease to a capital lease by classifying the leased asset as a purchased asset, which is included on the balance sheet as part of the company's assets.

The Financial Accounting Standards Board (FASB) issued a new Accounting Standards Update (ASU) in 2016 that requires all leases over twelve months to be both capitalized as an asset and recorded as a liability on the lessee's books, to fairly present both the rights and obligations of the lease.

Some types of long-term assets are capitalized but not depreciated. For example, the acquisition of land is capitalized. However, that land is not depreciated but is carried on the balance sheet at historical cost. The company may be required to reflect fair market value adjustments, though it may not record accumulated depreciation against the asset.

Finance

Another aspect of capitalization refers to the company's capital structure. Capitalization can refer to the book value cost of capital, which is the sum of a company's long-term debt, stock, and retained earnings. The alternative to the book value is the market value.

The market value cost of capital depends on the price of the company's stock. It is calculated by multiplying the price of the company’s shares by the number of shares outstanding in the market.

If the total number of shares outstanding is 1 billion and the stock is currently priced at $10, the market capitalization is $10 billion. Companies with a high market capitalization are referred to as large caps.

A company can be overcapitalized or undercapitalized. Undercapitalization occurs when earnings are not enough to cover the cost of capital, such as interest payments to bondholders or dividend payments to shareholders. Overcapitalization occurs when there's no need for outside capital because profits are high and earnings were underestimated.

Companies can only raise capital through a few methods; the long-term goal of a company is to be overcapitalized as it can return funds to investors, invest for growth, and still earn a profit.

Capitalization Thresholds

Generally, a company will set "capitalization thresholds." Any cash outlay over that amount will be capitalized if it is appropriate. Companies will set their own capitalization threshold because materiality varies by company size and industry. For example, a local mom-and-pop store may have a $500 capitalization threshold, while a global technology company may set its capitalization threshold at $10,000.

Financial statements can be manipulated when a cost is wrongly capitalized or expensed. If a cost is incorrectly expensed, net income in the current period will be lower than it otherwise should be. The company will also pay lower taxes in the current period. If a cost is incorrectly capitalized, net income in the current period will be higher than it otherwise should be. In addition, assets on the balance sheet will be overstated.

What Does Capitalization Mean in Accounting?

Capitalization is an accounting rule used to recognize a cash outlay as an asset on the balance sheet—rather than an expense on the income statement. The cost of fixed assets, such as computers, cars, and office buildings, are recorded on the general ledger as the historical cost of the asset and not expensed in full against earnings in the current accounting period. These costs are said to be capitalized, not expensed.

How Does Capitalization Impact Leased Equipment?

For leased equipment, capitalization is the conversion of an operating lease to a capital lease by classifying the leased asset as a purchased asset, which is included on the balance sheet as part of the company's assets. Leases over twelve months must be capitalized as an asset and recorded as a liability on the lessee's books.

What Does Capitalization Mean in Finance?

In finance, capitalization is a quantitative assessment of a firm's capital structure. Here it can refer to the book value cost of capital, which is the sum of a company's long-term debt, stock, and retained earnings. The alternative to the book value is the market value or market capitalization.

What Costs Can Be Capitalized?

Companies often set internal thresholds that establish what materiality levels exist for capitalizable assets. In general, costs that benefit future periods should be capitalized and expensed so that the expense of the asset is recognized in the same period as when the benefit is received.

In general, examples of costs that can be capitalized include development costs, construction costs, or capital assets such as equipment or vehicles.

What Is a Capitalization Strategy?

When a small company starts, it must create a capitalization strategy that outlines how the company will use its scarce resources to start operations. Based on initial forecasts, business owners may project how much financing they need to ensure profitability and sustainability until the company can be self-sustaining. Whether it is raising equity from a private investor, applying for debt, or contributing personal capital, these funding sources combined comprise of the capitalization strategy.

The Bottom Line

Capitalization refers to a few different things across business. In accounting, capitalization refers to long-term assets with future benefit. Instead of expensing costs as they occur, they may be depreciated over time as the benefit is received. In finance, capitalization refers to the financing structure and sourcing of funds.