Introduction
Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non-financial transactions and related information about businesses and corporations. Accountants are the ones who carry out the task of financial reporting, or accounting. Accounting is thousands of years old and can be traced back to ancient civilizations. Earlier, it was referred to as bookkeeping, the writing and counting of money.
Further, as the years passed, accounting evolved and was divided into several fields, which include financial accounting, management accounting, tax accounting, and cost accounting. Accountants make financial statements with the help of the standard rules of Generally Accepted Accounting Principles (GAAP).
Accounting helps us understand the economy of businesses, corporations, and the world and helps us maintain the balance and increase or decrease the value of a certain entity. Many people make subtle investments as per the accountant's statement, which considers all the fundamental values of the entity. The invested amount either takes a hit with a massive increase in amount or falls.
Capitalization is a type of accounting method that includes a cost that adds to the value of an asset and has to be incurred over the entire useful life of the asset. And amortisation is the accounting method that is used to periodically lower the book value of a loan or an intangible asset over a set time. As explained, both methods of capitalising and amortising add value to the asset over its useful life, while others lower the book value of the asset or even a loan.
In this article, we will be learning in-depth about capitalization and amortization, their features, and how each of the following affects the economy and differs from one another.
Amortization Vs. Capitalization
The methods of capitalization and amortisation for business expenses can spread tax benefits over several years as opposed to accounting for their full cost at once. Capitalization is the broader term, while amortisation is a special case. Meaning that capitalization is easy to carry out on a variety of assets, such as equipment, machinery, and so on, whereas amortisation is plausible for only intangible assets or loans.
Capitalization is when a business acquires or creates an asset that is of long-term use. It can be an impactful idea to account for the expense incurred over several years. For comparison purposes, a mortgage, a home loan, or a car loan—through instalment payments. Second, it is also known as the exercise of spreading out capital expenses—funds used by the company to acquire, upgrade, and maintain assets related to intangible assets—over a particular amount of time for accounting and tax purposes.
As we discussed, capitalization is the term that only applies to tangible assets—things that can be seen or touched—but amortisation applies to business assets that are intangible in nature, meaning things that aren't physical but still add value to the business entity. A few examples of intangible assets include business start-up costs, acquired trade names, licenses, patents, ventures, trademarks, and so on. Lenders, including financial institutions, use the timelines of the amortizations to establish a loan repayment plan that corresponds to a specific end of the term.
The process of amortisation and capitalization is nothing but the accounting method that measures the value of assets and loans, whether they are tangible or intangible. There are various calculations, budgets, spreadsheets, and other factors that could affect the way accounting can be carried out in either direction. After understanding each of the factors and the definition of the terms, one cannot perform the capitalization and amortisation accurately.
Difference between Amortization and Capitalization in Tabular form
| Parameters | Amortization | Capitalization |
| Meaning | An accounting technique used to periodically lower the book value of a loan or an intangible asset over a set time. | An accounting method that allows a newly-purchased asset to be depreciated over its useful life rather than being expensed in the current period. |
| History | The first ever known amortization was carried out in the year 1830. | The first ever known capitalization was carried out in the year 1851. |
| Financial perspective | Amortization in finance has two meanings. One in which the cost and expense of intangible assets are reflected and the other reflects the schedule of payments. | Capitalization in finance is a type of quantitative assessment of a firm's capital structure, which is a mix of a company's debt and equity to fund its overall operations and expansions. |
| Investors perspective | Amortization is essential because it assists businesses and investors in understanding and forecasting their costs in time. | The rates calculated through capitalization can be used to discriminate between different investment opportunities. |
| Use | The term amortisation is used for special cases and is the concept of borrowing. | Capitalization is used for asset-intensive activities, such as manufacturing, production, etc. |
| Examples | Home loans, auto loans, equity loans, and other types of loans are some examples of loans that amortize. | When the company purchases a good that can be used for years, the cost of that good will not be incurred but will be capitalised as a fixed asset. |
What is Amortization?
The term amortisation refers to two situations in finance. Firstly, amortisation is used in the process of paying off the debt through standard principal and interest payments over time. For this process, an amortisation schedule is used to reduce the current balance on a loan. For instance, a mortgage, a home loan, or a car loan—through an instalment payment. And secondly, it is also referred to as the practice of spreading out capital expenses—funds used by the company to acquire, upgrade, and maintain assets related to intangible assets—over a specific duration for accounting and tax purposes.
As per the aforementioned statement, amortisation refers to the process of paying off debt over time in regular instalments of interest (as decided beforehand by the lender and borrower) to repay the loan by its maturity date. The first and higher percentage of any monthly payment goes towards interest on the loan, and with each subsequent payment, a good percentage of it goes towards the loan's principal amount.
Amortizations can be calculated by using many modern financial calculators, excel spreadsheet packages, or even online platforms that provide umpteen features for amortisation calculations. When entering into a loan agreement, the lender may provide a copy of the amortisation schedule, which probably consists of the dates of the payments to be made.
As we all know, intangible assets are amortized (expensed) over time to tie the cost of the asset to the revenue it generates, following the matching principle of GAAP. Sometimes, negative amortisation might happen when payments on a loan are lower than the accumulated interest, which can cause a borrower to owe more money instead of less. For example, if the agreed amount for loan repayment in instalments is $100 and the borrower pays $90, then the interest rate is applied to the remaining $10 and the amount owed to the lender is increased.
What is Capitalization?
Capitalization is the expense of a fixed asset over its useful life; the useful life of an asset is an accounting estimate of the number of years it is likely to remain in service for cost-effective revenue generation. These fixed assets could be physical, i.e., tangible objects that are acquired by a business. For instance, the tangible assets that are commonly depreciated by the company or business include buildings, equipment, office furniture, vehicles, machinery, and so on.
There are two types of capitalization, one of which is plausible in finance and the other in accounting. The capitalization referred to in finance is for the company's capital structure. It is a book value cost of capital, which is the sum of a company's long-term debt, stock, and retained earnings. And there is also an alternative to book value, i.e., market value. In terms of accounting, the matching standard principle requires companies to record their expenses in the accounting period in which the related revenue is incurred. For instance, the company can make a larger purchase but expense it over many years, depending on the type of property, plant, or equipment involved. The same is not the case for small or moderate purchases, as they are recorded in the same accounting period of the year.
Many companies use this technique to make some savings in terms of taxation. As the financial statement can be manipulated when a cost is wrongly capitalised or expensed. If the cost is incorrectly expensed, the net income in the current period will be lower or higher depending upon the noted expense value. This will also have an impact on the taxes levied upon a company, as they too will be proportionate to the value of the expense shown in the record.
Main Difference Between Amortization and Capitalization in Points
- The first and known difference between the two terms is the definition of their functionality. Amortization is the accounting practice of spreading the cost of an intangible asset over its useful life. Capitalization is the expensing of a fixed asset over its useful life.
- In terms of applicability, capitalization is applied to only physical, tangible assets subject to having their costs allocated over their useful lives. On the other hand, amortisation is only applicable to intangible assets.
- In finance, the term "capitalization" is also known as depreciation, and depreciation means to diminish something's value over time. While the term "amortize" means to gradually write off a cost over a period.
- All the intangible assets are amortised over their useful lives using the straight-line method. This is one of the methods by which the same amount of amortisation expense is recognised each year. On the other hand, capitalization has several methods a company or business have the options to choose from.
- Out of all the methods to follow in capitalization, the most useful is accelerating depreciation. In this method, more capitalization expenses are recognised earlier in an asset's useful life. Tangible assets can use a modified accelerated cost recovery system (MACRS). While amortisation often does not use this practice, the same amount of expense is recognised whether the intangible asset is older or newer.
- The use of the salvage value in terms of both capitalization and amortisation is different; in capitalization, the depreciable base of tangible assets is reduced by the salvage value. While, in the case of amortization, the base of intangible assets is not reduced by the salvage value.
- The contra account is used in the general ledger to reduce the value of a related account. In capitalization, the entries always post accumulated depreciation to a contra account. In amortization, depending on the asset and materiality, the credit side of the amortisation entry may go directly to the intangible asset account.
- The history of both accounting methods can be traced back two centuries earlier. Amortization was first applied in the year 1830, while capitalization was first applied in the year 1851.
Conclusion
Amortization is a technique for gradually reducing an account balance over time. Loans are repaid over time by applying a progressively larger amount of the monthly debt payment to the principal. Amortization of intangible assets works in a similar way to depreciation in that a predetermined portion of the asset's book value is deducted each month. This methodology is used to demonstrate how a corporation benefits from an asset over time.
In the business, capitalization can relate to a number of different things. Capitalization in accounting refers to long-term assets with potential rewards. Costs may be depreciated over time when the benefit is obtained as opposed to being expensed as they are incurred. Capitalization in finance refers to the method of financing and the source of funds.
To account for the value of an asset and its related expenditures over time, there are two extensively employed strategies. Both capitalization and amortisation reduce the carrying value of assets and recognise expenses as assets are used over time. However, capitalization is used for physical assets, while amortisation is used for intangible assets. In addition, there are differences in the methods available, acceleration options, how to salvage value is used, and how contra accounts are used.
References
- Capitalization - Wikipedia
- Amortization - Wikipedia
- Depreciation vs. Amortization: What's the Difference? | Indeed.com
