Capitalisation is the addition to the balance sheet as an asset of an amount that could otherwise have been treated as an expense.
For example, if a part of R & D expenditure is capitalised it will be added to the balance sheet as an intangible asset, and then amortised. If it is not capitalised, then it will simply be shown as a cost on the P & L.
Capitalisation is a result of the accrual principle. Although accounting standards contain more detailed rules, the fundamental purpose of capitalisation is to allow the accrual of expenses in the current period to sales in future periods.
Expenses that may be capitalised include:
- development expenditure,
- computer software (but not all internal development costs),
- other intangible assets provided future benefits are probable and costs are reliably measurable,
- interest paid while while acquiring an asset or preparing it for use.
Investors may sometimes find it useful to adjust the accounts by capitalising expenses that a company does not capitalise. For example, capitalising all R & D in order to calculate a return on the investment made in R & D.
By capitalising a cost its impact on the current year's profits is greatly reduced, replacing the full cost with the amortisation on the cost. The assumption is that the cost creates future cash flows. It can therefore be regarded as acquiring an asset (the definition of an asset is something that creates future cash flows). So this asset can be shown in the balance sheet at its historical cost and amortised. If the cost can be accurately characterised as an investment that will create future cash flows, then this obviously adheres better to the accrual principle than taking the cost to the P & L immediately.