Journal Entry for Capitalization of Fixed Asset
Introduction
Capitalization of the fixed asset is the process of recording the cost of the asset that has a useful life longer than one accounting period to the balance sheet. Likewise, we can make the journal entry for capitalization of fixed asset when we purchase an asset that has a useful life longer than one accounting period.
Fixed asset is the type of asset that we purchase to use in business and has a useful life longer than one accounting period. Likewise, the fixed asset will provide benefits to the business for more than one accounting period. Hence, we should capitalize the cost of the fixed asset to the balance sheet upon purchase and allocate the capitalized cost of such fixed asset over the periods that it provides benefits to the business.
Likewise, this allocation of the capitalized cost of fixed asset is referred to as the depreciation of fixed asset in which we need to allocate a portion of fixed asset cost at the period end adjusting entry to the income statement in form of depreciation expense.
The capitalization of the fixed asset and allocating its cost over its useful life follow the matching principle of the accounting, in which the cost of the fixed asset should match with the benefits it provides to the business that should be more than one accounting period.
Journal entry for capitalization of fixed asset
Capitalize the cost of fixed asset to balance sheet
We can make the journal entry for capitalization of fixed asset by debiting the purchased cost of the asset into the fixed asset account and crediting the same amount into the cash account or payables account.
| Account | Debit | Credit |
|---|---|---|
| Fixed asset | $$$ | |
| Cash/payables | $$$ |
As mentioned, we capitalize the fixed asset so that we can spread the cost of the fixed asset over the periods that it provides benefit to the company. So, at the time of bringing the fixed asset into our business with the purchase, there is no expense for the income statement yet.
Likewise, this journal entry only impacts the balance sheet in form of either increasing one asset and decreasing another asset at the same time or increasing one asset together with the increase of one liability.
Allocate the cost of capitalized asset to income statement
As shown in the journal entry for capitalization of the fixed asset above, we do not record the expense immediately after purchasing the fixed asset. However, as we use the fixed asset for the period, the expense should incur as well in order to match the benefits we receive from the asset.
Likewise, we need to allocate the cost of the capitalized asset to each accounting period during the asset’s useful life. This allocation of the cost of capitalized asset is known as the depreciation of the fixed asset.
So, at the period-end adjusting entry, we need to make the journal entry to allocate the cost of the capitalized fixed asset to the income statement by debiting the depreciation expense account and crediting the accumulated depreciation account.
| Account | Debit | Credit |
|---|---|---|
| Depreciation expense | $$$ | |
| Accumulated depreciation | $$$ |
In this journal entry, the depreciation expense is an income statement item while the accumulated depreciation is a contra account to the fixed asset on the balance sheet. Likewise, while total expenses increase, total assets decrease as a result of allocating the cost of the capitalized asset to the income statement.
Capitalization of fixed asset example
For example, on January 1, we make a cash purchase of equipment that cost $21,000 to use in our business. This cost includes all necessary costs that bring the equipment to our office premise and ready to be used. We expect the equipment to have four years of useful life in our business with the salvage value of $1,000 at the end of its useful life.
Additionally, we expect the equipment to provide similar benefits to our business for each accounting period over the four years of its useful life. Our reporting date of the year-end is December 31 which we will make all necessary adjusting entries and close the account for the period.
What is the journal entry for capitalization of fixed asset on January 1 and allocation of the capitalized cost of the fixed asset on December 31?
Solution:
Capitalization of fixed asset on January 1
With the information in the example, we can capitalize the equipment that cost $21,000 as a fixed asset on the balance sheet with the journal entry of debiting the $21,000 amount into the equipment account and crediting the same amount into the cash account.
| Account | Debit | Credit |
|---|---|---|
| Equipment | 21,000 | |
| Cash | 21,000 |
In this journal entry, the $21,000 cost of the equipment is capitalized as a fixed asset on the balance sheet. And this cost will be depreciated for four years period in order to match the equipment cost to the benefits it is expected to provide to our business over its useful life of four years.
Allocation of capitalized cost of fixed asset
As the equipment is expected to provide similar benefits to our business each year during the four years period, we can use the straight-line depreciation method to calculate the depreciation for the allocation of the capitalized equipment that needs to be recorded as an expense during the period in the income statement as below:
Deprecation of equipment = ($21,000 – $1,000) / 4 years = $5,000 per year
As a result, we can make the journal entry on December 31 for the allocation cost of the $21,000 capitalized fixed asset to the income statement as below:
| Account | Debit | Credit |
|---|---|---|
| Depreciation expense | 5,000 | |
| Accumulated depreciation – equipment | 5,000 |
In this journal entry, total expenses on the income statement increase by $5,000 as the result of allocating a quarter of the fixed cost into the first accounting period. At the same time, the total assets on the balance decrease by the same amount of $5,000.
