What is the Capitalization Policy? Example and Explanation

Introduction

A capitalization policy is a guideline or a threshold set by the company itself. Capitalization includes debt and the value of the capital stock of a company. Above the capitalization policy, all the expenses are recorded as fixed assets expenditure, whereas below the capitalization policy, all the expenses are recorded as expenses incurred.

The thresholds set by businesses for the capitalization policy are set by the highest executives, and vary a lot from business to business. It can be quite different for small and big businesses. The small businesses according to their requirements may set a capitalization policy of as low as one thousand dollars, whereas big businesses can set up a capitalization policy beginning from fifty thousand dollars.

Explanation

A company puts a capitalization threshold to differentiate between assets and expenses. Sometimes, assets can be of very low cost such that they are noted as expenses. This can create a problem on the balance sheet side of the company. To avoid these issues, the company issues capitalization policy guidelines based on past experiences and future expectations. The capitalization policy also differentiates between capital expenditure and whether CAPEX should be part of a larger asset or noted as a different asset.

Example

Consider a non-profit business that provides low-cost ambulance services. One of its biggest expenses is the oxygen tanks. It can go through dozen of these in a single day. Each one of the Oxygen tanks costs about one hundred dollars.  The non-profit company decides that its capitalization policy is one hundred and twenty dollars. So, the oxygen tanks would be now considered an expense because they are under the capitalization policy.

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If the capitalization policy would have been under one hundred dollars, the oxygen tanks would have been classified as fixed assets.

Types of capitalization policies

The types of capitalizations are given in figure 1 below:

Figure 1: Two types of Capitalization

There are two types of capitalizations that are shown in figure 1 are undercapitalization and overcapitalization. The details about various forms, their limitations, and why these occur are explained below:

Under Capitalization

Under normal conditions, undercapitalization may be associated with lack of capital, but, under real conditions, it is considered to be an opposite condition of overcapitalization, where the book value, value of assets, and cash holdings, is more than the capitalization of the company.

Causes of under capitalization

The causes of undercapitalization are as follows:

Underestimating of earnings

One of the main causes of undercapitalization associated with a company is its underestimation of earnings. The publically listed companies provide forward guidance. Sometimes, the forecast of the company may be under expected. The actual earnings may be higher. Other times, the company may beat market expectations, when the market was expecting lower income earnings for the company.  

All of these reasons lead to a lower capitalization of a company, which in turn leads to an undercapitalization policy of a company.

Unexpected Increase in income

Sometimes, due to unforeseen circumstances, the company may get an unexpected increase in earnings. There can be a multitude of reasons why this happens. The market conditions may have become more favorable or a competitor may have gone bankrupt. This would have resulted in higher prices for the product or service that a company makes.

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This increase in income would show a mismatch in the book value of the company versus the capitalization of the company.

High production efficiency

If a company produces products or services with the utmost efficiency, the capital requirements, especially for fixed assets such as equipment or machinery tend to go down. Because the company is using one machine more efficiently, it reduces the need for buying another machine. This would result in a lower capital expenditure requirement which would be translated into a lower capitalization policy set by the board of the company.

Over Capitalization

Over capitalization is the reverse of undercapitalization. Over capitalization happens when the book value of the company, net cash, and assets, is lower than the capitalization of the company.

Causes of Over Capitalization

The causes for overcapitalization are given as follows:

Inflated assets

The inflated assets would definitely result in the overcapitalization of a company. That is because if the value of the asset is inflated, the capitalization of a company would also have to be high to determine that particular machinery or equipment is an asset. The inflated value of that asset would then result in the overcapitalization of that company caused by a high capitalization policy.

Economy is in boom

When the economy is booming, the company’s earning becomes inflated due to a general rise in inflation. This results in boosted income for the company, which results in the capitalization of the company being higher than usual. This scenario leads to overcapitalization.

Bright forecast

The company would increase its capitalization if it expects a huge boom in earnings. Sometimes, companies may paint a bright picture of their future expected earnings, which spreads optimism all around and which leads to a high earning forecast, which forces the board to review its capitalization policy and increase its capitalization policy, in almost all cases.

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Capital inefficient use

If the company is not using its equipment and machinery efficiently, the rate of use of capital would be lower. This lower capital efficiency would result in lower use of capital, which means more capital would be required to produce the same amount of products, had the capital efficiency been higher. This would naturally require the board of the company to increase its capitalization policy.

Conclusion

The capitalization policy is a very important part of how a company classifies its expenses and assets. The capitalization policy can show where does the priority of a company lie. The capitalization policy also varies a lot depending upon the industry in which it is being used, and for what purposes it is being used.

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