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Having a large number of fixed assets can be a lot of work to manage. And recording small accounting transactions may seem like more trouble than they’re worth!

However, implementing a capitalization threshold helps you effectively track the fixed assets that will be used in the long run and expense the smaller, more inconsequential purchases. This can make asset management much more organized and efficient. 

In this article, we will explain the ins and out of capitalization thresholds for your business assets. 

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What is Capitalization?

Depending on who you ask, capitalization is either the provision of capital for a company or the conversion of assets into capital. That is because there are two uses of the word capitalization:

  • In accounting, capitalizations are seen as cash expenditures recognized as an asset on the balance sheet instead of expenses listed on the income statement. The cost of the asset is expensed over its useful life instead of solely expensed in the reporting period it was purchased. 

 

  • In finance, capitalization refers to the total or book value of a company’s debt and equity. The term market capitalization refers to how much the company’s outstanding shares are worth. To calculate the market cap, simply multiply the current market price by the total number of outstanding shares. 

In this article, we are going to stick with the accountants’ use of capitalization. Accounting’s matching principle states that companies must record expenses in the same accounting period as the revenues they are related to. The purpose is to maintain consistency across the company’s income statements and balance sheets. 

Capitalization is applied to fixed, tangible assets. This means they are to be recorded on the general ledger with their historical cost. For this reason, they are capitalized and not expensed. Fixed assets, or capital assets, include tangible things such as:

To qualify for capitalization of a fixed asset, the IRS states that the item must have a useful life of at least one year. It has to be productive in the operations of the business. If investments like vacant land are not used for business operations, they will not qualify. 

Assets that don’t meet the IRS qualifications will be considered an expense and recorded to the income statement instead. These include business resources that will expire or be consumed by the business within one year or one accounting cycle (depending on which is longer). 

Fixed assets are not capitalized all at once when they are purchased. Instead, the process can be drawn out throughout their useful lives in which they help generate revenue for the company. The asset will be recorded on the balance sheet, where it will increase the worth of the company.

How long they are capitalized upon will depend on what asset categories of property, plant, or equipment are involved. As the asset ages, its value to the company is reduced. While the business asset is losing value, its loss of value must be recorded as depreciation.

This is not to be confused with the process taken for intangible assets, which is known as amortization. Deciding whether or not to capitalize on an asset will affect the recorded profits and losses of your business. Inevitably, this will affect things like its net worth, tax liability, and ability to qualify for a loan. 

That is why it is essential to set a capitalization threshold for your fixed assets. 

What is a Capitalization Threshold?

With the multitude of expenditures that come with running a business, there are balance sheet entries. This means working to maintain and manage the asset. However, for small expenditures, this may be a waste of time and money put into the process. 

For example, small office supply purchases may be used and disposed of in the same period they are purchased. The time it takes to record and track these small purchases may not even be worth it. For this reason, capitalization thresholds or capitalization limits can be established within the business.

A capitalization threshold is a minimum cost at which the fixed asset should be recorded in your accounting system. So if the asset is valued:

  • Above the threshold: The organization will capitalize purchased or constructed assets on the balance sheet

 

  • Below the threshold: The organization will charge purchases to expenses on the income statement

Capitalization thresholds are most often used by companies that make use of taxpayer funding. This could include organizations like public schools, local government offices, public libraries, etc. To ensure good faith, stewardship, and transparency, these organizations must track and disclose what is being spent with taxpayers’ money. 

Since these are all government-run organizations, this means their capitalization policies must be determined elsewhere. 

Who Determines Capitalization Thresholds?

Thresholds are determined in a variety of ways, including through regulatory bodies and policies. Some of them are:

  • GASB 34: In June 1999, the Government Accounting Standards Board (GASB) issued GASB Statement #34 Basic Financial Statements and Management Discussion and Analysis for State and Local Governments. This Statement resulted in sweeping changes in governmental entities’ financial reporting. 

 

  • OMB A-133: In 1990, OMB Circular A-133 was issued. It expanded the 1984 Single Audit Act which stated a single audit can be completed for all recipients to be used by all Federal agencies. The OMB A-133 covered nonprofit organizations as well as Institutes of Higher Education (IHEs) that received over a dollar threshold. 

 

  • The organizations themselves: Organizations can come up with their capitalization thresholds. This could be based on things like audit requirements, or the goals of their accounting system. Small businesses should consult an auditor before establishing their capitalization policy. 

Not only are there regulatory bodies that can set capitalization limits, but there are also a set of accounting standards that can be utilized when capitalizing assets. Generally Accepted Accounting Principles (GAAP) will allow organizations to include several other acquisition costs related to the purchase to represent the total cost of the fixed asset.

Along with the purchase price, these include things like: 

  • Related sales taxes of the purchase
  • Labor and construction costs to produce the item
  • Assembly costs
  • Installations costs
  • Property site preparation costs
  • Closing costs
  • Title and mortgage fees
  • Professional fees for services rendered, such as those for architects and inspectors
  • Repair and maintenance costs that keep the asset in efficient operating condition during its useful life (such as building improvements including new doors and windows)
  • Loan interest costs incurred for purchases to maintain or restore the operation of an asset
  • Import duties
  • Inbound shipping and handling costs

Small business owners may wonder if they need to set and apply capitalization thresholds. The answer lies in the businesses’ unique needs since every organization is different. Let’s explore how to determine whether to apply a capitalization threshold and how to set your cap limit if you do. 

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Determining Whether to Apply Capitalization Threshold

The Internal Revenue Service (IRS) has established guidelines for tangible assets that help govern businesses record keeping procedures. Firstly, the IRS stipulates that fixed assets should be capitalized if they have a useful life that extends over a fiscal year and is used in business operations.  

The IRS recommends a technique for you to determine whether or not to capitalize on your expenditures. It is called the BAR test. BAR is an acronym for:

  • Betterment 
  • Adaptation
  • Restoration

The expenditure should be capitalized when it results in the Betterment, Adaptation, or Restoration of the unit of property. What happens if the purchase does not apply to any of these three things? It would instead be treated as an expense and be deducted on the income statement. 

But if you decide you want to capitalize on the asset, you will need to know how to set the capitalization limit. How do you set a cap limit for your business capitalization policy?

How To Set Your Cap Limit

In regards to capitalization policies, the IRS suggests business owners apply de minimis safe harbor threshold mentioned in Notice 2015-82. This threshold ranges from $2,500 to $5,000 per invoice or item. The applicable financial statement (AFS) will allow you to safely deduct these amounts used to purchase the tangible property. 

You can, however, decide to come up with higher or lower capitalization thresholds for your own business. However, be aware that the IRS requires that you use the same threshold on your taxes as you do on your accounting books.

Set your limit based on the present-day and forecasted needs of your business. 

  • Low cap limit: If you set your capitalization limit very low, this will cause some expenditures to be capitalized as assets when they typically would be charged as expenses. As a result, your short-term profits will look higher. However, this means you will have larger depreciation expenses down the line because eventually the assets will be charged to expenses. Keep in mind you will have a larger fixed assets register. This means you will be charged more personal property taxes, possibly for years to come. You are likely to see more cash going out in the form of taxes than if you had set a higher limit.

 

  • High cap limit: If you set your cap limit on the higher end, this means some of your expensive purchases will be charged as expenses for the period in which they were purchased. Although you will save your accounting staff some work, the added expenses will be reflected as large differences in month-to-month profits and not accurately depict your balance sheet. Remember that setting your limit high will mean you have fewer reportable assets. This looks suspicious and could trigger an audit by the IRS, which can be time-consuming and costly for your business.

What happens when the fixed asset is leased? To capitalize, the leased asset must be classified as a purchased asset and be converted from an operating lease to a capital lease. This should appear on the balance sheet as a part of the company’s assets. 

According to FASB, as of 2016, all leases over a year must be recorded as a capitalized asset and as a liability to fairly represent both the rights and obligations that a lease brings to a company. 

How to Capitalize Your Assets

To manage and capitalize your assets, you will want to have a system for easy and quick reporting and tracking. Businesses often use things like spreadsheets, internal databases, or computer software to efficiently and accurately track capital items. 

Once you’ve gotten your accounting policies in place and you’ve set your cap limit, it is time to capitalize those assets that hit the threshold. Here is how to reconcile eligible fixed asset purchases on the balance sheet: 

  1. Find the individual item’s purchase cost
  2. Add to this how much it cost you to secure the asset (as stipulated per GAAP and IRS accounting standards). This number will represent the total cost of the fixed asset
  3. Determine or estimate the asset’s useful life (Typically represented in years)
  4. Next, take the total cost number found in Step 2, and divide it by the asset’s estimated useful life found in Step 3 
  5. Add the depreciation to the books. This can be done either annually or monthly

Capitalization Thresholds Affect Funding Eligibility

The capitalization threshold is the minimum cost at which a fixed asset is recorded in an organization’s accounting system. If the asset’s total cost is above the threshold, it will be capitalized as an asset on the balance sheet.

If the asset’s total cost is below this threshold, it will be added as an expense on the income statement. Whether you set your cap limit high or low, this will greatly affect your business’s recorded profits and losses. Inevitably, this will affect things like its net worth, tax liability, and ability to qualify for a business loan.

Here at Coastal Kapital, we want you to succeed by having every resource at your disposal, including funding. Therefore, we hope this article has offered you some guidance as you set and implement your accounting policies.

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