Photo credit: Pickawood
Sometimes the best topics to discuss here are the ones we, as accountants, overlook. Recently, our marketing consultant asked us a question about capitalizing vs. expensing items he purchases, either for use in developing content or on behalf of his clients. This got us thinking: if he has this question, how many other folks have the same accounting issue?
What is capitalization?
Capitalization is a method of accounting in which a cost is included in the value of an asset and expensed (through depreciation) over the useful life of that asset. In contrast, an expense is a short-lived or inexpensive purchase consumed in the normal course of business. An obvious expense would be a stapler. They aren’t expensive, and to track them on the books would be silly because the time spent doing that outweighs the value of the item. On the other hand, a company truck would be considered an asset because it will provide benefits for a long period. The truck should be capitalized; while the gas and repairs should be expensed, as they are consumed right away. These examples are pretty intuitive, but businesses often have purchases that are not so obvious. How do you decide when something is worth tracking as an asset? At what point does it become capitalized? In accounting we call that a capitalization threshold.
Simply put, a capitalization threshold deals with the level that a company sets to treat an expenditure as an asset vs. an expense.
Setting a capitalization threshold
Depending on the size of the company and the number of assets they control, capitalization thresholds vary in dollar amount. Most companies Lucrum works with use $500 or $1,000. Meaning, anything less than that amount is expensed. Purchases over that amount are capitalized as assets on the balance sheet and depreciated. Yes, it might appear to be a somewhat arbitrary number but it saves businesses and accounting departments from having to track the minutiae of small purchases. If your business hasn’t set capitalization thresholds yet, contact us for help. While businesses can decide their own thresholds, these numbers need to be in line with regulatory policies.
It is worth noting, the bulk purchase of smaller items does not trigger capitalization. Even if the total purchase amount exceeds the threshold. For example, Lucrum has a tree removal client who routinely buys safety gear in the slow winter time. This few thousand-dollar purchase is not capitalized because it is made up of dozens of small items such as chaps, helmets, earmuffs, and rigging items, which would individually be under the capitalization threshold. Typically, Lucrum sets up a “Small Tools and Equipment <500” account that is used for capturing these expenses on a contractor’s books.
The purpose of the purchase matters
Our marketing guy had also been improperly capitalizing items he purchased on his client’s behalf, and creating a lot of extra work for himself in the process by having to maintain a detailed depreciation schedule of these items. Lucrum uses an account called “Client Expenses” for things we purchase on our client’s behalf, so we recommended he set up and start using this account going forward.
Expenses vs. Cost of Sales
When thinking through these accounts and classifications, it is important to consider whether to classify these Client Expense or Small Tools accounts as Expense accounts or Cost of Sales accounts. While they have the same impact on the balance sheet, Cost of Sales impacts Gross Profit, which is a very important metric in most, if not all, businesses.
Again, some definitions would be helpful here. Cost of Sales are expenditures incurred in the production of revenue. Expenses are simply consumed in the normal course of business (think: overhead). So, the key determining factor becomes: is the purchase related to generating revenue? In our marketing guy example, the answer is yes, and Cost of Sales is the correct location for this account. The answer is the same with the Small Tools account for our tree-care client since the safety gear is worn by the folks in the field doing the actual tree work. If we were buying computers or other things for our own business that didn’t relate to revenue generation, they would be expensed as an overhead item.
Cost of Sales are expenditures incurred in the production of revenue. Expenses are simply consumed in the normal course of business (think: overhead).
We’ve tried to give a general overview here. This can get pretty technical. Using the example of buying a company truck, we would probably treat a $1,000 repair bill as an expense, provided it didn’t significantly extend the life of the truck (most likely, it simply restored the truck to proper working order). Now, replacing an entire engine, or something as extensive as that, would substantially improve the truck and probably should be capitalized. If this is making your head swim, give us a call. Small business leaders can quickly get bogged down in the weeds of this type of issue, and that is an ineffective use of their time. It may not be time to bring on a full-time CFO yet, but our Fractional CFO options are custom fit for exactly this kind of situation.
When do you capitalize an asset?
- The amount of the purchase is above your capitalization threshold
- The purchase will add value to your company for a long time
Hopefully, this article explains some of the reasoning behind setting a capitalization threshold as well as determining which account is best suited for a particular expenditure. Properly classifying expenditures as overhead, cost of sales, or assets will provide much more clarity to business performance and help business owners better understand the health of their company. Proper classification is often one of the first things we fix for a new client- it’s “low-hanging fruit” that we can easily correct and make a big impact in a little time. But shhh!, that’s just between us, right?