What it is:
How it works (Example):
Companies capitalize the cost of asset purchases in order to spread out the cost of the assets over many reporting periods. This way, net income is not affected disproportionately in the reporting period in which the asset was purchased.
Rather than being listed as one large expense in one reporting period, a capitalized asset cost will be expensed via depreciation over many reporting periods. On the balance sheet, it will appear as a long-term asset and cash debit. The income statement will also account for a portion of the asset's cost via depreciation expenses.
To illustrate, suppose Company XYZ purchases equipment for $10,000. Rather than report the full $10,000 cost in that period, the company characterizes the purchase as a $10,000 long-term asset. On the balance sheet, the long-term asset account increases and the cash account decreases by $10,000.
As the long-term asset depreciates, the depreciation expense is reported on the income statement. As a result, Company XYZ's bottom line is not grossly affected by the substantial asset purchase in that period. The remainder of the $10,000 will, however, need to be continually reported as a depreciation expense until the asset has fully depreciated.
Why it Matters:
Management's decision as to whether to capitalize or expense a purchase has a direct impact on its bottom line. If a company were to report the total cost of an asset purchase as an expense on its income statement (which is to say not capitalize), the cost, depending on the size, it would significantly reduce their net income figure for the reporting period.
Because earnings are probably the single most important indicator of a company's financial strength and growth potential, they are used by investment analysts to provide estimates of a company's growth potential and offer target price estimates for investors interested in purchasing shares. Therefore, company management has a huge interest in managing the way earnings are reported.