Deciding whether to expense or capitalize fixed assets is one of the most difficult concepts for business owners to grasp. Pretend for a moment you buy a vehicle to be used solely for business. You know it can’t be expensed, so you record it as a fixed asset. Easy, right? But what if you buy a computer, rightly record it as a fixed asset, but then later need printer to go with it. Should that printer be expensed, or should it also be capitalized? Things can get fuzzy quickly.
Accounting standards are great at telling people how to capitalize a fixed asset, but they often don’t provide a lot of guidance on exactly which assets to capitalize and how to depreciate the ones you do capitalize. As a business owner, you obviously have a lot of expenses, so how do you decipher the rules? Here’s a bit of guidance.
Understanding Capitalization (or, “How to know what your accountant is talking about.”)
To capitalize an asset is to put it on your balance sheet instead of “expensing" it. So if you spend $1,000 on a piece of equipment, rather than report a $1,000 expense immediately, you list the equipment on the balance sheet as an asset worth $1,000. Then, as time goes on, you amortize (depreciate) the asset over its useful life, taking a depreciation expense each year and reducing the balance-sheet value of the asset by the amount of the expense. The process of capitalization essentially allows your company to spread the cost of the asset over its useful life and avoid drastic impacts to the income statement in the period the asset was purchased.
When we say, “fixed asset”, we’re talking about an item that is used by a company in the operation of business. Fixed assets are usually expensive in nature and do not include inventory for resale or repair or spare parts inventory. Typically, an item is not considered to be an asset to be capitalized unless it has a useful life of at least one year. Additionally, fixed assets are generally thought be items that are new or replacement in nature, rather than for the repair of an item. Examples of fixed assets include:
- Purchase price of the item and related taxes
- Construction cost of the item, which can include labor and employee benefits
- Import duties
- Inbound freight and handling
- Interest costs incurred during the period required to bring an asset to the condition and location necessary for its intended use
- Site preparation
- Installation and assembly
- Asset startup testing
- Professional fees
- The cost of major periodic replacements (e.g., a new roof)
Writing Your Capitalization Policy
It's a smart idea for your business to adopt its own customized fixed asset capitalization policy. This will be used as a guide in determining the level expenditures should be capitalized. Issues to consider include the size of your business, the use of your customary capital items, your level of revenues and expenses, and compliance needs -- both tax depreciation report and property tax (if applicable). This policy can also be helpful in the construction of a capital asset budget for future periods by identifying which items should be capitalized. And, perhaps most importantly, the written policy provides a defense in the event a financial audit is conducted on the company.
Most accounting organizations set minimum purchase thresholds for an item to be considered a fixed asset. The purpose of the capitalization threshold is to prevent the business from placing immaterial expenses on the balance sheet instead of recognizing them as an expense in the period incurred. There is no set value for a capitalization threshold, but the Internal Revenue Service indicates that most items with a useful life of more than one year should be capitalized.
Does this mean that the $25 keyboard you purchased for the above mentioned PC should be capitalized and depreciated over the next five years? Not necessarily. Here are two things to keep in mind:
- The de minimis rule: The de minimis rule allows you to expense any item that may be potentially capitalized so long as said expense (or the sum of related expenses) does not significantly distort your bottom line. In other words, these expenses do not make up a large percentage of your total expenses, subsequently providing you with extraordinary low income. A good rule of thumb is they should be less than 0.1% of your gross receipts for the year, and/or 2% of your total depreciation and amortization expense for the year.
- The economic useful life: If the items purchased are used for one year and have no value after 12 months then they may be expensed. The only consideration here is timing; buying in December and consuming in January is frowned upon by IRS. But, if those expenses do not distort your bottom line, you could argue for the deduction.
These two areas are a good place to start when determining when to expense and when to capitalize. Still, a written policy is your best bet to ensure consistency and defend yourself should IRS contest your expenditures.
Even with these guidelines, deciding whether to expense or capitalize can be tricky. Never hesitate to contact us for clarification.