Capitalisation
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 comprises of share capital, debentures, loans, free reserves,etc. Capitalization represents permanent investment in companies excluding long-term loans. Capitalization can be distinguished from capital structure. Capital structure is a broad term and it deals with qualitative aspect of finance. While capitalization is a narrow term and it deals with the quantitative aspect.
Capitalization is generally found to be of following types-
- Normal
- Over
- Under
Modern Concept of Capitalisation:
Though the narrower interpretation of capitalisation is more popular because of its being very specific in the meaning, the modern thinkers consider that even short-term creditors should be included in capitalisation.
In the words of Walker and Baughn, “The use of capitalisation refers to only long-term debt and capital stock; and short-term creditors do not constitute suppliers of capital is erroneous. In reality total capital is furnished by short-term creditors and long-term creditors.”
They further opine that the sum of capital stock and long-term debt-refers to capital rather than the capitalisation.
Thus, according to modern concept, capitalisation includes:
(i) Share Capital
(ii) Long-term Debt.
(iii) Reserves and Surplus.
(iv) Short-term Debt.
(v) Creditors.
Need of Capitalisation:
The need of capitalisation arises not only at the time of incorporation or promotion of a company but may also arise as a going concern after promotion and during the life time of a corporation.
Generally, the problem of capitalisation arises in the following circumstance:
i. At the time of promotion/incorporation of a company.
ii. At the time of expansion of an existing company.
iii. At the time of amalgamation and absorption of two or more companies.
iv. At the time of re-organisation of capital of a company.
Theories of Capitalisation:
There are two important theories to determine the amount of capitalisation:
(i) The Cost Theory, and
(ii) The Earnings Theory.
(i) The Cost Theory of Capitalisation:
According to this theory, the amount of capitalisation is arrived at by adding up the cost of fixed assets (like plants, machinery, building, etc.); working capital required for the continuous operations of the company; the cost of establishing the company and the promotional expenses.
Such calculation of capitalisation is useful in case of newly-formed companies as it enables the promoters to know exactly the amount of funds to be raised. But, this theory is not totally satisfactory as it ignores the earning capacity of the business. The amount of capitalisation is based on a figure which will not change with changes in the earning capacity of the business.
(ii) The Earnings Theory of Capitalisation:
The earnings theory of capitalisation recognises the fact that true value of an enterprise depends upon its earning capacity.
According to this theory, the capitalisation of a company depends upon its earnings and the expected fair rate of return on its capital invested. Thus, the value of capitalisation is equal to the capitalised value of the estimated earnings.
