Accrual-basis accounting chooses to recognise transactions by recording their existence on the accounts at the times of their occurrence. Since figures can still be unclear at the times of occurrence, some estimation is needed to produce useful numbers that can be compiled into financial statements. Over time, accounting rules and standards sprang up to guide accountants in performing these estimations. One of these rules is the matching principle, and it is this principle that led to the usage of the capitalisation procedure for certain business expenditures.
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The matching principle requires that accountants record expenses in the same time periods as the revenues and/or benefits produced through their occurrence. Since some business expenditures produce benefits across multiple time periods, the values of these expenditures are required by the matching principle to be spread out across those multiple time periods.
Capital and revenue expenditures
Business expenditures can be divided into capital and revenue expenditures. Revenue expenditures are recorded on the income statement as expenses and are treated thus because their occurrence produces benefits in a single time period. In contrast, capital expenditures are recorded on the balance sheet as assets in a process called capitalisation because their occurrence helps produce benefits across multiple time periods. Capitalisation occurs because the values of capital expenditures should be spread out across multiple time periods using depreciation.
Capital expenditures and preexisting assets
Some capital expenditures have their values added onto pre-existing base assets to be depreciated with said assets because their occurrence increased the assets' usefulness in some manner. For example, if a renovation project repaired a dilapidated building and restored a portion of its usefulness lost to use, the costs of that renovation project will be added onto the building's value during capitalisation. Capital expenditures improving a base asset can change other parameters of the base asset, such as its useful lifespan and residual value upon disposal, which can drastically change its depreciation expense per period.
Capital expenditures and intangible assets
In other cases, capital expenditures are capitalised as brand-new intangible assets because there was no base asset to add on to. For example, if a research and development project led to a patent that is expected to produce revenues for the business, those research and development costs will be capitalised as an intangible asset called a patent. Such assets are subjected to a similar procedure to depreciation called amortisation so that their values can be spread out across the multiple time periods of their usage as expenses.
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