Capitalization refers to the process of raising funds (capital) to operate a business by issuing Stock or debt.
The term capitalization also refers to recording the cost of a product or service as an Asset, rather than as an expense.
A firm’s capital structure is defined as the percentage of total capitalization that was raised by issuing stock vs. debt. If a company issues stock, the purchasers are owners (shareholders), while purchasers of debt are defined as creditors.
Each type of stakeholder creates a different set of expectations for the issuing company:
Shareholders: Stock purchasers are owners of the business, and these owners typically have the right to vote on major corporate decisions, such as a company merger or sale. Many firms reward shareholders by paying a cash dividend out of company earnings, and shareholders can also benefit if the business performs well and they can sell their shares for a gain.
Bondholders: The most common form of debt issued is a corporate bond, and these bonds pay interest twice a year. The issuing company is obligated to pay interest each year, and to repay the principal amount of the bond when the bond reaches maturity. Corporate bonds trade on exchanges, just as stocks do, and the investor can sell the bond before maturity.
The capital structure of a firm can vary greatly, depending on the company’s ability to generate consistent earnings. Businesses that generate profits each year are more likely to issue debt, because they can make interest and principal payments on a timely basis. On the other hand, firms that don’t generate consistent earnings must issue equity.
An example, assume that an auto parts manufacturer issues 5,000 shares of $10 par value stock for $35 per share. Par value is an accounting term that is used to value each share of common stock posted to the balance sheet. The dollar amount above $10 par value per share is posted to additional paid in capital. The manufacturer also issues $150,000 in 5% corporate bonds due in 10 years.
Here is the dollar amount of capital raised by the manufacturer:
$150,000 5% corporate bonds due in 10 years
$50,000 Common stock (5,000 shares of $10 par value stock)
$125,000 Additional paid in capital (5,000 shares at $25 per share)
$175,000 Total shareholder’s equity (5,000 shares at $35 per share)
Long-term debt is 46% of the capital structure, and equity is 54% of the total.
Capitalization also refers to recording the cost of a product or services to an asset account, rather than as an expense. The decision to capitalize is connected to the definition of an asset, and to the matching principle.
An asset is defined as a resource that is used to generate revenue (sales) and profits, and an asset should be reclassified into an expense account during its useful life. As a company uses an asset to generate revenue, the cost of the asset is gradually moved into depreciation expense.
Depreciating an asset ensures that revenue generated from using the asset is matched with an expense. By matching revenue with related expenses, a business will generate net income that reflects the true profitability of the business.
Some purchases are small, or the useful life of the asset cannot be accurately estimated. These costs are immediately expensed as they are incurred. The accounting principle of conservatism states that, when in doubt, a business should report an expense immediately, rather than delay reporting the expense. Posting an expense quickly reduces net income, which presents a more conservative level of profitability.
Every business should have a capitalization policy, and the policy should state that each asset purchase below a specific dollar amount should be immediately expensed. Posting a purchase to an asset account requires the business to track depreciation, and setting a capitalization policy reduces the total number of assets that must be accounted for each month.
Assume, for example, that the auto parts manufacturer has a policy that each purchase below $500 should be immediately expensed. The manufacturer makes three purchases in the third week of March:
Office supplies $200
Sod for office landscaping $400
The cost of office supplies and sod are expensed immediately, and the machinery cost is posted to an asset account and depreciated over an estimated useful life.
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