How do you decide when to capitalize rather than expense a purchase?
Answer
If the asset has a useful life of over 1 year it is capitalized (put on the Balance Sheet rather than shown as an expense on the IS).
Then it is depreciated (tangible assets) or amortized (intangible assets) over a certain number of years. Just keeping this one short it’s a true check the box.
Why this matters to bankers
Incorrectly expensing a purchase when it should have been capitalized can have a dramatically negative impact on profitability. Let’s say that a factory is purchased for $100 and has a useful life of 10 years. This should be capitalized at an expense of $10 per year. If it was expensed, it would reduce profitability in the year it was purchased by $100. Meaning that if it was not dealt with correctly, it would reduce profitability by $90.