Capitalization

Capitalization, in accounting, is when the costs to acquire an asset are expensed over the life of that asset rather than in the period it was incurred. In finance, capitalization is the sum of a corporation's stock, long-term debt, and retained earnings.

Capitalization also refers to the number of outstanding shares multiplied by share price.

Capitalization has two meanings in accounting and finance. In accounting, capitalization is an accounting rule used primarily by capital-intensive companies, such as manufacturing or construction, where depreciation can be a large portion of total expenses. In finance, capitalization is a quantitative assessment of a firm's capital structure.

In accounting, the goal is to record revenue and expenses in the period when they are incurred. For example, office supplies are generally expensed in the period when they are incurred since they are expected to be consumed within a short period of time. However, some office equipment may provide a benefit to the business for more than one accounting period. These are fixed assets such as computers, cars, and office buildings. The costs of these items are recorded as assets to be used over a longer period of time. These costs are said to be capitalized, not expensed. Accountants like capitalized assets because they are not expensed against earnings in the current period. A company can make a large purchase but expense it over a 20- to 30-year period. As these assets are used to generate revenue, a portion of the cost is written off. This process is known as depreciation or amortization.

For leased equipment, capitalization is the conversion of an operating lease to a capital lease by classifying the leased asset as a purchased asset which is recorded on the balance sheet as part of the company's assets. The value of the asset that will be assigned is either its fair market value or the present value of the lease payments, whichever is less. Also, the amount of principal owed is recorded as a liability on the balance sheet.

Financial statements can be manipulated when a cost is expensed, instead of capitalized. If this occurs, current income will be inflated at the expense of future periods over which additional depreciation will now be charged.

Another aspect of capitalization refers to the company's capital structure. Capitalization can refer to the book value of capital, which is the sum of a company's long-term debt, stock, and retained earnings.

The alternative to the book value is the market value. The market value of capital depends on the price of the company's stock. It is calculated by multiplying the price of the company’s shares by the number of shares outstanding in the market. If the total number of shares outstanding is 1 billion and the stock is currently priced at $10, the market capitalization is $10 billion. Companies with a high market capitalization are referred to as large caps; companies with medium market capitalization are referred to as mid caps; and companies with small capitalization are referred to as small caps.

It is possible to be overcapitalized or undercapitalized. Overcapitalization occurs when earnings are not enough to cover the cost of capital such as interest payments to bondholders, or dividend payments to shareholders. Undercapitalization occurs when there's no need for outside capital because profits are high and earnings were underestimated.