Capitalization and Its Impact on Financial Reports

A company’s balance sheet states its performance, as it contains all the important information that is required to perform day-to-day activities. However, the major part of it is properly recording the costs of each and every cost of a specific activity. This is where the financial term “capitalization” appears. It records certain costs by spreading them over a year rather than immediately stating them on the balance sheet as immediate expenses. In this way, it presents a clear picture of all the financial expenditure for better planning and enhanced profitability.

What Does It Mean to Capitalize?

When a company buys machinery, software, or property that is expected to generate profits for many years, then the capitalization technique is used to reflect this. This technique records the cost of an expense as a long-term investment (considering an asset) rather than recording it as an immediate expense on the balance sheet.

Instead of impacting the current income statement, the company spread the expenses over the assets’ functional life, displaying it as a long-term investment on the balance sheet.

In accounting, the term ‘capitalize” refers to documenting the cost of an asset on the balance sheet, rather than considering it as an immediately applicable expense. In this approach, the cost of an asset can be depreciated or amortized throughout its useful lifespan.

This technique helps to match the expenses with the revenue that the assets will generate. Capitalizing assets makes the financial income statement more stable and accurate, improves financial ratios, and aligns cash flow with expenses.

There are various types of costs that a company can capitalize on a balance sheet, like

Property, plant, and equipment (PP&E) – such as real estate, tools, or equipment.

Intangible assets- such as patents, trademarks, or applications

Research and development costs.

The decision of whether to capitalize an expense or record it as an immediate expense is made by the accounting team on a case-by-case basis.

Capitalization considers the following two thoughts

Capitalize all large expenses that are above the predefined internal threshold, which will generate revenue in the future.

Capitalize only those expenses that provide benefits for the long term.

The first method is more impactful, as it reduces the expenses in the current year and increases depreciation expenses in the following years. (indicates more profits)

The second method is traditional and realistic, as the expenses on the income statement are presented in a more reasonable structure.

But the final decision of how to treat expenses is entirely based on the company’s overall financial strategy.

What is Capitalization?

When a business invests money in things that are considered fixed or long-term assets, the business can capitalize such costs. This means the costs are recorded on the balance sheet as an asset instead of being recorded as the business’s immediate expenses on the income statement.

Such capitalized cost of assets is gradually transferred as expenses through depreciation for physical assets or amortization for intangible assets.

For instance, if a manufacturing company buys heavy equipment worth $100,000 and it has an expected life span of 10 years. The company records the amount of $100,000 on the balance sheet as an asset. After that, each year they record $10,000 as a depreciation expense; in this way, the capitalized asset is gradually divided into incremental expenses incurred over its useful life instead of recording the full amount immediately in the year it was brought.

Impact of Capitalization on the Company’s Financial Reporting

Balance sheet: If a company capitalizes assets, it results in an increase in total assets. This might affect the company’s return on assets value and make it look financially stronger for a while.

Effect on income statements: When a company’s expenses are capitalized, profits appear on the higher side in the shorter term as the cost is distributed over many years instead of being recorded immediately.

Cash flow statements: It does not impact the real cash outflow but hits the income statement and balance sheet. The cash flow statement is recorded under “full cash payment” under the investing activities when assets are purchased.

Different accounting regulations have their own rules for identifying capitalization. In U.S. GAAP, generally accepted accounting principles contain a detailed set of rules for specific asset groups, whereas IFRS, international financial reporting standards, implement a wider principle-based approach to offer flexibility to companies in finalizing what to capitalize.

Before any system capitalizes an asset, the cost of expenditure must fulfill the definition of an asset. Let’s consider an example of leased equipment, where this approach refers to a leased asset as a purchased asset; therefore, an operating lease is converted into a capital lease on the balance sheet.

Under the FASB, Financial Accounting Standards Board regulations, all leases longer than 12 months must be capitalized to clearly reflect the company’s right to use the asset and the obligations it carries.

Note – If the cost is incorrectly capitalized, it may lead to fraudulent financial statements.

If a cost that should be capitalized is recorded as expensed, then the net income in the current year will be lower, resulting in lower tax payments in that current period.

If a cost that should be expensed is instead capitalized, then the net income in the current year will be higher, and assets on the balance sheet will be overvalued.

To ensure that the financial report is accurate and reliable, conveying proper capitalization is important.

Capitalization under GAAP and IFRS

1. GAAP, Generally Accepted Accounting Principles (U.S. Standards)

Specific, detailed guidelines for specified industries

Allows capitalization only for development costs like software and media production

Demands only capitalization of interest costs.

2. IFRS, International Financial Reporting Standards (International Standards)

Applying a general rule of probable future economic benefits means costs can be capitalized only if they generate future benefits.

Capitalization of development costs is allowed for any industry until its feasibility is proved.

Makes capitalization of interest cost optional for companies.

What are the Types of Capitalization in Finance?

Normal Capitalization: We have already learned about the normal capitalization in the above sections. In simple terms, it is the estimation or valuation of a company’s current value. So we will move ahead with the remaining two types of capitalization.

Undercapitalization: When a company is capable of generating higher profits, then that company is said to be undercapitalized. In this approach, the expected earnings are quite low compared to the original profit.

Therefore, the company makes extra profits, more funds, high-level earnings, and a good status. As a result, the company appears to be smaller, but its actual earnings are high due to increasing return on investment (ROI).

The different reasons for a company’s undercapitalization are as follows:

Purchasing assets at very low rates

Spending less on promotion expenses

Conservative dividend policy

Highly efficient directors

Flotation of the company during the economic downfall

Support large secret reserves

Maintain depreciation provision

Consequences of Undercapitalization

On Company: In this approach, the company earns more than the estimated profit; therefore, its status increases, but it also

Increases the level of competition and creates challenges for the company as well.

Employees may demand higher wages since the company is now performing above expectations.

Additionally, the customer may feel that the company is charging too high or overcharging for its services and products.

On shareholders: It benefits the shareholders because,

The company’s earnings increase; hence, it becomes more profitable.

The market value of company shares increases.

Therefore, shareholders expect higher dividends

This builds a company’s financial reputation strongly.

On society: The higher market value of shares, earnings, and profitability creates mixed opinions in society.

Unhealthy speculations circulate in the stock market.

Consumers may feel that the high profitability is due to high commodity and service prices.

As the companies maintain a secret reserve, a low amount of tax is paid, which may serve as a reason for concern among the public.

The general public or clients may expect better technology, innovative moves, and high-quality products from such companies.

Overcapitalization: It takes place when a company has raised more capital or money than its actual requirement. Due to this, some portion of the excess capital remains idle; therefore, the company does not have adequate profits to pay back interest on loans or debentures or pay dividends to its shareholders.

In simple terms, overcapitalization occurs when a company raises capital but does not make enough profit to repay interest on loans. Therefore, the return on investment keeps declining.

The following are some of the reasons behind overcapitalization:

High promotion or marketing cost

Insufficient provisions for depreciation purposes

Flotation of the company during the boom period

Liberal dividend policy

Overestimation of the company’s total earnings

Consequences of Overcapitalization:

On the company: All overcapitalized companies earn less profit; therefore, the reputation of the company goes down. Due to this,

It becomes difficult to market or sell the shares of the company.

The company is bound to cut down essential expenses such as maintenance, depreciation, asset replacement, etc.

The company may practice unfair practices such as the manipulation of accounts to disguise its poor performance.

On shareholders: All overcapitalized companies generate lower profitability. Due to which,

The rate of earnings of the shareholder decreases, and hence the shareholder also suffers.

Additionally, the market value of shares also decreases because of lower profits.

On the public: When a company is overcapitalized, it will create a negative financial impact on the public. Because,

The management team may follow malpractices such as increasing prices or decreasing the quality of products or services.

The company may delay the payments, as they do not have sufficient capital to pay the creditors on time.

This creates a poor impression, and the public starts losing trust in the company.

It leads to poor working conditions and lower wages or salaries for the employees

How Does Capitalization Define a Company’s Capital Structure?

Capitalization also defines a company’s capital structure, which is a combination of both long-term and permanent funding. Here, it refers to the amount of funds a company raises from equity stock, long-term debt, and retained earnings. In simple terms, it defines how a company finances its entire operations and development by utilizing different sources of funds.

The company’s capital structure indicates different sources of funds to run its business:

Equity capital: it includes common stock, preferred stock, and retained earnings. It is the type of corporate ownership fund, so the company is not required to make fixed repayments to equity holders; however, it can pay dividends.

Debt capital: It includes long-term or permanent financial instruments such as long-term loans, bonds, and debentures. Companies must repay their debt capital with its interest

Hybrid securities: It is the combination of both debt and equity, for example, convertible bonds.

Companies having a significant amount of capital are considered to have a high equity base as compared to debt; these companies are considered more tolerable to economic crises and also can handle them more efficiently.

The weighted average cost of capital (WACC) refers to the average cost of capital sources like debt and equity. WACC defines the minimum target profit margin a company must achieve to keep their stakeholders happy. However, smarter businesses carefully decide the appropriate combinations of funds to keep the costs low while maintaining financial flexibility and navigating uncertain risks.

If a company is undercapitalized, it is unable to generate sufficient revenues to meet the costs needed to finance its operations. This means the company has to struggle while making interest payments to lenders or dividend payments to shareholders.

On the other hand, overcapitalization happens when a company raises more money than it actually needs. Even though this sounds positive, it leads to waste—some funds remain unused, and the company may miss out on better investment opportunities elsewhere.

Finding the right level of capitalization is important for a company’s long-term success.

Capitalization Ratio: It is essential to evaluate a company’s capital structure. For instance, if a company is more dependent on equity, it might have a higher cost of capital. Equity typically demands higher returns compared to debt, thereby missing the tax benefit that comes with paying interest on a tax-deductible basis.

Whereas, if a company is too much dependent on debt financing, it becomes risky to pay interest and loan payments for them.

Formula to calculate capitalization ratio:

Debt-to-equity D/E=Total DebtShareholders’ Equity

Long-term debt capitalization= Long term debtLong term debt+Shareholders’ Equity

Total debt to capitalization= Total debtTotal debt+Shareholders’ Equity

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Conclusion

By understanding the financial term “capitalization,” we can say that it is helpful for the financial managers, as it capitalizes the assets and provides better clarity of their expenses. Proper funding of assets means profits and losses are presented in a more improved form on the balance sheet. Therefore, companies must carefully understand the pros and cons of implementing this approach. A clear financial statement provides a better opportunity for future planning and boosts the financial health of the company.