Why do we capitalize assets verse just expensing them to the income statement?
The correct answer and explanation is:
Assets are capitalized on the balance sheet instead of being expensed immediately on the income statement for several key reasons related to matching principle and the long-term benefit of the asset.
- Matching Principle: One of the core principles of accounting is the matching principle, which requires that expenses be recognized in the same period as the revenues they help generate. When a company buys an asset, like equipment or property, it expects to use that asset over many years. Expensing the entire cost in the year of purchase would not accurately match the expense with the revenue generated over the asset’s useful life. Instead, the cost is spread out over several periods through depreciation or amortization.
- Materiality: The cost of certain assets may be too large to expense all at once. Capitalizing assets allows a company to distribute the cost over time, making it more manageable in the context of its financial performance. Large expenditures, like buildings or machinery, provide value over a long period, and treating them as immediate expenses would distort the financial results.
- Balance Sheet Representation: By capitalizing assets, a company reflects the true value of what it owns on the balance sheet. This can affect financial ratios such as return on assets (ROA) and leverage ratios, providing a more accurate picture of the company’s financial position. If the asset were expensed, it would not appear as an asset on the balance sheet, which would misrepresent the company’s resources.
- Tax Considerations: Capitalizing an asset and depreciating it over time can lead to tax benefits. Some countries allow businesses to deduct depreciation as an expense, which lowers taxable income over several years, rather than deducting the entire cost in one year.
In summary, capitalizing assets ensures the financial statements reflect the true long-term value of the asset while adhering to accounting principles like matching expenses with revenues. It also improves the accuracy of the company’s balance sheet and supports proper tax planning.