Accounting: Why Capitalize Major Purchases?
Fixed assets, also known as capital equipment, include such items as manufacturing equipment, computers, furniture & fixtures, vehicles and software. To qualify for capitalization, they must benefit the business for longer than one year and generally have a minimum purchase price set by company policy (such as $500 or $1,000.)
The first reason to capitalize major equipment is to better align its expense with revenue generated during the time it is in use. If an expensive purchase is posted to the Profit and Loss Statement as an expense, it will skew the purchase month’s results, showing larger operating expense and less net income. Subsequent months will show no expense even though the company continues to benefit from the use of the equipment. By capitalizing the asset (holding it as an Asset on the Balance Sheet), the impact of the purchase is spread to the Profit and Loss Statement evenly over a given period of time through depreciation entries.
The second reason to hold major assets on the Balance Sheet is to recognize that the company owns something of value. This value can be used to borrow against, or even to sell if the need for cash exceeds the usefulness of the equipment. Showing the full value of assets on the Balance Sheet aids investors and creditors in assessing the financial health of the company.
After posting the purchase to a Fixed Asset account (on the Balance Sheet), the next step is to schedule depreciation. The most commonly used depreciation method is “straight line”. This method divides the total purchase amount (including sales tax, installation, and shipping) by the number of periods in the life of the asset to determine the monthly depreciation. The entry in the general ledger is to debit Depreciation Expense (Profit & Loss Statement) and credit Accumulated Depreciation (Balance Sheet.) The net value of the asset is decreased monthly until it is fully depreciated or it taken out of service.
Even if you purchase assets as a group, it is best to schedule depreciation for each item that could be sold or retired separately from the group. As an example, a computer purchase might include a CPU with extra internal parts, a monitor, and a printer. It is unlikely that the internal parts would be removed from the CPU, but the monitor and printer could easily be sold or retired. Therefore this purchase should depreciate the CPU, monitor and printer as 3 line items.
Be aware that your CPA will use different rules when preparing your tax return. Often the full purchase amount is written off as a Sect. 179 deduction on your tax return even though you have capitalized it and are depreciating the asset over time.