Why Your Startup Needs an Asset Capitalization Policy
…and what it will do for your income statement & balance sheet.
Entrepreneurs and small business owners are usually more focused on refining their competitive strategies, and less interested in their accounting policies — completely understandable. But once a startup is ready to acquire the technology and equipment it needs to begin operations, having an asset capitalization policy becomes absolutely critical.
Asset capitalization policies help companies ensure that their purchases are properly accounted for. Without a written policy, companies run the risk of expensing something that should have been capitalized (or vice versa). This can quickly distort their financial statements, and cause companies to under/overpay the IRS at tax time.
This article explains the basics of an asset capitalization policy and the risks faced by companies without one. By the end, you will understand the difference between a capital purchase and an operating expense, and how each one affects the income statement and balance sheet.
What Makes Something an Asset?
As a general rule, everything a company buys must either classified as an operating expense, or a capital asset. Whether something can be considered an asset depends on how long it will benefit the company. At a minimum, a capital asset must have an estimated useful life of at least one year. Accounting standards define an asset’s useful life as…
“the period over which the asset is expected to contribute directly or indirectly to future cash flows”
In other words, an asset’s useful life is based on how long it will help the company make money, not how long it will last.
As an example, think about how in some retail stores, the sales associates use tablets to better assist customers. Unlike other store supplies like paper towels or ink pens, a tablet will help the company generate revenue for another 5–7 years. The cost of the tablet would be capitalized as an asset on the balance sheet, where it would be slowly depreciated (written off) over the next 5–7 years. On the other hand, it is highly unlikely that the paper towels and ink pens will still be around next year, so the cost of those items would be expensed (written off) right away.
The Financial Statement Impact
Capital assets and operating expenses affect the financial statements in completely different ways. Operating expenses are deducted from the company’s gross profit, so the more operating expenses a company has on its income statement, the less profitable it appears. Instead of reducing company profits, the cost of a capital asset is added to the long-term asset section of the balance sheet as “property, plant, and equipment” (PP&E). The more assets a company has on its balance sheet, the stronger it appears.
Without a capitalization policy, capital assets can easily be recorded as operating expenses by mistake. Such a mistake would have a negative impact on both the income statement and the balance sheet. The balance sheet would make the company appear weaker than it really was (since the value of the newly-acquired item wasn’t included in the long-term asset section of the balance sheet, and it should’ve been), and the income statement would make the company appear less profitable than it really was (since the cost of the newly-acquired item was classified as an operating expense and deducted from gross profit).
Why Every Startup Should Care
Anyone in the startup world will tell you that a solid set of financial statements is essential for securing outside funding. During their first few years, startups often spend a considerable amount of money to acquire the operating equipment and technology they need to begin operations. More often than not, those types of major purchases should be classified as capital assets, and asset capitalization policies help to accomplish that.
Implementing an asset capitalization policy helps startups to classify their costs more consistently, which allows their financial statements to paint a much brighter picture than they would otherwise.
A Real Life Example
If a company buys a $100,000 robot that it expects to use for the next 10 years, that would be its estimated useful life. Instead of being expensed right away like a roll of paper towels, the robot would be capitalized as an asset. The asset would be added to the long-term assets on the balance sheet, and then depreciated so that the expense is spread out over its 10 year useful life.
At the end of the first year, depreciation expense of $10,000 is recorded ($100,000/10 years) for the robot. The $10,000 depreciation expense reduces both the company’s reported net income earned for the year by $10,000, and the value of the robot on the company’s balance sheet from $100,000 to $90,000. This process repeats for the next nine years until the robot’s value on the balance sheet is written down to $0.
If the company didn’t have a capitalization policy, there’s a good chance that the entire $100,000 would’ve been expensed in the year it was purchased, causing both long-term assets and net income to be understated by $100,000.
Developing a Capitalization Policy
Asset capitalization policies are guaranteed to help companies be more consistent in how they decide which costs to capitalize and which ones to expense. Most companies set a monetary threshold, where if the cost of a purchase exceeds the specified amount, it is capitalized, and those that fall below it are expensed. Using a threshold is very efficient; and due to its simplicity, employees can pick it up pretty easily— even if they don’t have much accounting experience.
When developing your company’s policy, think about what types of things you expect to buy most often, then go from there. Some policies might specify that anything bought at a gas station or convenience store is automatically expensed (since neither place really offers anything that will last more than a year), while others might only allow purchases from an approved list of vendors to be capitalized.
Key Takeaways
Don’t worry about creating a policy that’s absolutely perfect. It’s completely normal for companies to update and revise their policies as time goes on or circumstances change.
Ultimately, an asset capitalization policy will help your financial statements paint a more accurate picture of the business — which is something every company should strive for.
