4.4 When Should a Company Capitalize or Expense an Item?

Fixed assets are tangible items used in business operations for more than one accounting period. They're crucial for generating revenue and must meet specific criteria to be recognized as assets on the balance sheet.

Depreciation allocates the cost of fixed assets over their useful lives, matching expenses with revenue. Companies can choose between straight-line and accelerated depreciation methods, impacting financial statements differently over time.

Fixed Assets and Depreciation

Criteria for fixed assets

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• Tangible item possesses a physical form (machinery, buildings, vehicles)
• Acquired for use in business operations generates revenue, not for resale
• Expected to provide benefits for more than one accounting period typically used for more than one year
• Cost of the item can be reliably measured includes purchase price, taxes, delivery charges, and installation costs
• Asset recognition criteria must be met according to accounting standards

Depreciation and cost allocation

• Depreciation allocates the cost of a fixed asset over its useful life the period the asset is expected to provide economic benefits
• Depreciation expense is recorded each accounting period matches the cost of the asset with the revenue it helps generate
• Accumulated depreciation represents the total depreciation expense recorded since the asset was acquired
• Straight-line depreciation method allocates an equal amount of depreciation expense each year
  • $Annual Depreciation = \frac{Cost - [Salvage Value](https://www.fiveableKeyTerm:Salvage_Value)}{Useful Life}$
  • Salvage value estimates the value of the asset at the end of its useful life
• Accelerated depreciation methods allocate more depreciation expense in the early years of an asset's life (double-declining balance, sum-of-the-years' digits)

Expensing vs capitalizing effects

• Expensing an item immediately records the entire cost as an expense in the current period
  • Reduces net income and retained earnings in the current period
  • No impact on future periods
• Capitalizing an item records the cost as a fixed asset on the balance sheet
  • Cost is allocated over the asset's useful life through depreciation expense
  • Higher net income and retained earnings in the year of acquisition compared to expensing
  • Lower net income in future periods due to depreciation expense
• Capitalizing results in a higher total asset balance on the balance sheet fixed assets are reported at their cost less accumulated depreciation
• Expensing results in lower total assets and stockholders' equity compared to capitalizing
• Cash flow is not affected by the choice to expense or capitalize both methods result in the same cash outflow in the year of acquisition

Accounting Standards and Considerations

• Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) provide guidelines for asset recognition and capitalization
• Materiality is a key factor in determining whether to capitalize or expense an item
• Companies often establish a capitalization threshold, below which purchases are expensed regardless of useful life