Capitalization in Small Businesses for Earning Rate Valuations

The owners of small companies often search for capitalization policies for their business. The term capitalization indicates how a small business accounts for the purchase of materials that are needed to run the business smoothly. There are certain rules and regulations about when to capitalize on places, persons, and things for increasing the success rate of the business. Today in this article we will guide you to know about the concept of capitalization assets, the importance of capitalization, and how capitalization works in small business companies.

You will also learn about setting up a customized capitalization policy which will help you to account for the expenditures of the business. Read the article till the end, thus it will make sure that you get proper knowledge about capitalization policies for small businesses.

When Should A Small Business capitalize 

When a small business owner purchases some items for his/her company, the business owner should decide if he wants to capitalize the purchases as a fixed asset which would make an impact on the balance sheet, or expense the purchases which would make an impact in the income statement.

In the capitalization process, the business owner has to “Depreciate” or “Amortize” a part of the price of the purchases made at regular intervals in a particular period of time. The capitalization process will record the price of an asset in the balance sheet and thus it will help the business owners to increase the worth of the company and lower its value to the company by a no. of Journal entries made on an annual or monthly basis. The process of capitalizing on an asset will greatly impact the profits and losses of a business. Therefore the business owners have to make decisions very wisely regarding capitalizing on an asset. And thus the profit and loss of the company will affect the net worth of the company and tax liability of the company. You can use some smart tax reduction hacks to maintain your tax liability.

As the capitalization process creates a large impact on the worth of the company, the professional accountants and the IRS have set some rules and regulations for understanding a fixed asset and an expense. Now let us have a look at what is a fixed asset and what is an expense

What is Fixed Asset

The term Fixed asset means a long term resource that is used to run the business, for example, any type of equipment, property, etc

The qualities that are needed to be an asset are:-

  • The product or the material should have a life of one year or more than one year.
  • The item must be productive and useful to run the business.
  • Any vacant land and building is not considered as a fixed asset because presently these are not used to run your business.

What is Expense 

The term Expense means a resource that will be utilized by the business within a year or will be utilized within the normal operating cycle of the business. The normal operating cycle of a business denotes the time period in which the business buys a product and sells it to the customers.

Internal Revenue Principles & Guidelines for Capitalization

Capitalization policy follows some of the principles and guidelines, check what are they, and how they follow for the process;

Generally Accepted Accounting Principles (GAAP) Fixed Asset Inclusions

There are many costs included in fixed assets beyond the base purchase price of an item. The GAAP allows the business owners to include various costs beyond the base purchase price of an item. Now let us have a look at those costs which are included in the fixed assets by GAAP

  • The cost of labour and construction needed to produce any item.
  • The amount of money needed for installation and assembly.
  • Cost of importing items, are included in the fixed assets GAAP.
  • The money needed for inbound shipping and handling.
  • Cost of construction of the site and mortgage fees.
  • The money needed for paying architects and inspectors.
  • Money needed for repairing and maintaining the assets.
  • The amount of money which is paid as interest of different loans.

Internal Revenue Service Fixed Asset Guidelines

The IRS has issued “Tangible Property” rules and regulations in order to govern the fixed asset record-keeping of a business. The rules of the IRS states that “The fixed assets of a business should be capitalized at a certain threshold”.

The IRS also introduced “A unit of property” which means that while the fixed assets expenditures are being summed up you have to look at whether the components are functionally interdependent or not. For example:- if you buy new tires for your truck, the truck and the new are considered as a unit of property.

In order to decide whether the expenditure should be capitalized or not, you can use another technique known as the BAR test. BAR stands for Betterment Adaptation Restoration. If the purchase results in Betterment, Adaptation, and Restoration of the unit of property, then you can capitalize the purchase. And if the purchase fails the BAR test, then you have to consider it as an expense and deduct it from the income statement.

Internal Revenue Service Fixed Asset Thresholds

The capitalization threshold for fixed assets set by the IRS is either $2,500 or $5,000. The price of the item or product must meet or exceed the threshold set by the IRS.

The business owners can also set their own threshold for fixed assets. The IRS suggests that business owners should use the same threshold for tax purposes as well as for accounting purposes. 

Working of the capitalization process

In order to capitalize the fixed asset expenditure of your business, you have to go through a no. of exercise for each potential fixed asset. Let us have a look at those steps

  • First of all you have to find out the base acquisition cost of the fixed asset.
  • Then you have to follow the GAAP and IRS guidelines to add any cost to the base price in order to secure the asset.
  • Then you have to select a useful life time period for that asset.
  • Divide the total price of the fixed asset by the time factor.
  • Then the resulting amount on the books should be depreciated.
  • Now record the depreciation either monthly or annually.

How to Write A Capitalization Policy

Every small business should create a capitalization policy in writing for the company. This will help your accountants and bookkeepers to stop the entry of unnecessary expenses in the balance sheet. Let us have a look at some of the benefits provided by a written capitalization policy

  • It will help you to increase the consistency of accounting.
  • Also decrease the record keeping expenses.
  • This will give you a base to make a capital asset budget.
  • If an IRS audit occurs, then it will help you to defend the business.

Thus the process of capitalizing the fixed assets is a bit tricky and it takes a lot of time. Therefore you have to create a capitalization policy for the whole company which will help you to get more accounting benefits in your small business.

Wrapping Up

We hope that now you completely know when and what should be capitalized in small businesses. Just follow all the points carefully, the guidance provided in this article will definitely help you to know when and what should be capitalized in small business in a hassle-free method. We will recommend you to read the entire article and follow all the points without skipping a single point. Still, if you have any doubts regarding the capitalization policy then you can contact the Wizxpert experts to get a clear vision regarding this topic.

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