Deciding whether to deduct an expense in full or capitalize and amortize it over its useful life is usually a difficult question for small business owners. The accounting treatment of a major purchase can sometimes make the difference between a year-end income statement that shows a profit and one that shows a loss. Business owners don't often understand how each method affects your income statement as well as the tax ramifications of the decision. Here's a breakdown when to expense and when to capitalize.
Capitalizing a purchase
This is an accounting method that delays the recognition of expenses by recording the expense as a long-term asset. Instead of expensing the full cost in the year of purchase, you will spread the cost over an extended period of time, which provides a more accurate picture of your profitability. For example, you decide to capitalize a $20,000 expense and amortize it over a five-year period. Instead of taking all of this expense in 2017, you will record $4,000 per year over the next five years as amortization expense. In order to capitalize an asset, it must have a useful life that extends beyond the current year and you must use the asset to conduct your business. Assets may be fixed assets, such as equipment and furniture, or even intangible assets, such as copyrights and patents.
Expensing a purchase
Deciding to expense a large purchase in the current year can be both beneficial and detrimental to your business. Incurring a large expense will lower your taxable income and therefore reduce the tax liability of your business and its owners. Everyone loves to avoid paying taxes but beware that expensing all of an asset in a single year may prevent you from receiving the benefit of depreciation or amortization expense in the future. You may get a huge tax break in the year of purchase, but could end up owing more money over the next three to five years. Expensing an asset in a single year can also skew your income to expense ratios and provide an inaccurate picture of your company’s profitability.
Deciding to expense or capitalize doesn’t have to be a difficult decision for small business owners. Some companies set a purchasing limit and anything below this amount will be expensed and anything above that amount will be amortized (capitalized). This is a quick and effective way to simplify the decision. Just remember that the item must also have a useful life beyond the current year in order to be capitalized.
Not sure what to do? Contact a reputable bookkeeper, like The Bean Counters Bookkeeping who can not only keep track of your expenses, but advise on the best way to handle large purchases come tax time.