The principle of assets capitalisation is very crucial in the business environment of UAE in financial reporting and accounting. It can be defined in that it relates to capturing the cost of an asset in the balance sheet rather than immediately recording the asset in the expense category. The practice is relevant to the companies that aim to present the companies financial health correctly and comply with the requirements. In this blog we will understand what is capitalisation of assets, why it is necessary and how it affects the financial statements.
What Does Capitalisation of Assets Amount to?
In accounting, capitalisation is the accounting treatment that records an expenditure as an asset instead of recording it as an expense. When a firm acquires some asset, whether it is a property, plant or equipment and intangible assets, the firm will have to decide whether to capitalise the cost incurred per annum or to treat it as an expense immediately. Capitalisation refers to the process of recording the cost of the asset in balance sheet, which is depreciated or amortised according to the useful life.
Capitalisation of assets aids businesses to align costs with their revenues generated with the help of assets a fact known in accrual accounting. According to the accounting standards of the UAE, which follows the accounting standards governing international practices like IFRS (International Financial Reporting Standards), companies are required to capitalise some expenditures that are treated as valuable to the company as they run their courses in the future.
What is the significance of capitalisation of assets?
Capitalisation of assets is a critical procedure due to a number of reasons:
- Financial Accuracy: Capitalisation makes sure that the financial position of the company reflects the financial position in a better and correct way. By capitalising the cost of the asset, businesses are therefore spreading the cost of asset over its useful life and it helps them in not distorting the profit and loss account.
- Tax Implications: Tax incentives could be granted to businesses depending on the capitalised assets in the UAE because the depreciation on the capitalised assets is used in ascertaining taxable income. This assists companies in avoiding their tax burden as the years go by
- Investment and Funding: Investors and lenders would look at the valuation of assets of a company to make their decisions. By having assets capitalised, the companies are in a better financial position hence more investments and facilities to lend on them.
- Regulatory Compliance: This covers following the accounting standards such as those issued by the purchasing country or in case of international companies across different countries. This aspect helps to adhere to the set regulatory frameworks, by avoiding penalties and other legal problems.
The Capitalisation of Assets Process
Capitalisation of assets has a number of steps to follow, and the knowledge of this process could help businesses to adhere to the steps.
The first step (step 1) is to determine capitalisable expenditures.
The initial thing to do is to identify the expenditures that are able to be capitalised Accounting theories hold that a company must capitalise the expenses associated with the acquisition of any asset that will have future economic advantages. This property may involve machines, equipments, buildings, assets and intangibles such as patents, trademarks and the likes.
All expenditures that do not lead to long term gain e.g. regular repairs and maintenance should not be capitalised. Business should critically analyze every cost so they make the right decision.
Step 2: Record Cost of the Asset
When an asset has been identified to be capitalised it then needs to have its cost recorded. This is the purchase cost and any other costs incurred directly as a result of making the asset usable e.g. Cost of installation, of shipping. It is also necessary to remember that the interest spent on the construction or implementation of the asset can also be capitalised.
Step 3: Depreciation of asset
The second phase of calculation after capitalisation is distribution of cost of asset over several years. Amortisation of an intangible and depreciation of physical assets are put in place to capture the usage of the asset value in the asset over the passage of time.
Depreciation is usually pursued in well-organized manner by business firms in the UAE, including straight line or reducing balance method, depending on nature of the asset. This is because through the process, the companies can be able to compare the cost of the asset and the revenue it is generating.
Types of assets that are eligible to be capitalised.
There are numerous types of assets which are usually capitalised in accounting especially those that are done to a business in the UAE:
Tangible Assets
Physical assets are real items which may last long term. These include:
- Property and Real Estate: The land and buildings purchased to be used in business.
- Machinery and Equipment: They are assets put into use in the framing or working of the business.
- Vehicles: Business vehicles include trucks, cars and other vehicle bought to fuel the business.
Intangible Assets
Intangible assets refer to those assets that do not have physical realities but have a value; and these categories include:
- Patents and trademarks: This is the intellectual property that can earn you money with time.
- Goodwill: Reputation and brand, customer base of a company.
- Software: Software that has useful life of over one year, which is purchased.
Professional Perspective on Capitalisation of Assets
Indeed, as financial expert John Smith notes, capitalising assets is not a process that involves accounting but it is a process of creating financial story that incorporates long term value of investment that a person owns. Smith states that businesses usually have difficulties with capitalisation as it is not easy to distinguish between the costs that should be capitalised and other operational expenses. Nevertheless, he points out that it is important to nail this properly not only to provide right reports on financials but also to achieve strategic planning on finance matters.
Capitalisation and Balance Sheet
- The manner of capitalisation of the assets, to a great extent, influences the financial reporting of a company. Here’s how:
- Balance Sheet: Capitalising assets means the total assets increase in a company on the balance sheet. This can help in enhancing financial wellbeing of the company and present the company as stronger to investors and lenders.
- Income Statement: Businesses can afford to capitalise assets and thus spread the cost of an asset over time and it may not cause significant implications on the income statement in the current accounting period. This has the capacity of enhancing short-term profitability because the entire cost of financing the asset is not written off at that single moment.
- Cash Flow Statement: Capitalising the asset itself does not affect the cash flow of the business affected but the depreciation or amortization of the asset capitalised may have some effect on operating cash flow because it will reduce the amount of taxes paid.
- The most common errors encountered in capitalisation of assets are as follows.
- Capitalisation of assets is a requirement, but the companies do not follow it properly leading to wrong financial reporting:
- Improper Capitalisation of Expenses: Capitalisation of expenses which are to be expensed in the present year as in the case of regular maintenance expenses. This may result into over-pricing of assets and overdeclaration of profits.
- Failure to reevaluate useful life: The life of assets may deteriorate as the years go through. By failing to reassess useful life of an asset, a business may end up under-depreciating or over-depreciating such an asset.
- Misreporting Disposal: Companies can overlook the cost of an asset and my not add depreciation on to the asset at the time of disposal, this also poses as an error in the financial statement.
Prologue: The Importance of Capitalisation
The aspect of capitalisation of assets is an important aspect affecting businesses doing business in the UAE and it relates with the financial statements of businesses, tax planning, and financial strategy. Well capitalised assets aid businesses to have correct financial reports, adhere to regulations and formulate proper decisions about future investments. Capitalisation is also significant in tax planning whereby capitalisation enables businesses to lessen their taxable level of income in the form of depreciation.
Finally, learning about the implications found in capitalising the assets and the effect it may have on the financial statements can also be invaluable in the efforts of the companies to learn to manoeuvre through the ruses of the accounting standards and to increase the monetary potential.
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