LOS C requires us to:
explain and evaluate how capitalizing versus expensing costs in the period in which they are incurred affects financial statements and ratios.
1. Impact on the Net Income
a. If the cost of an asset is capitalized, in the initial year the net income would be higher than if it would have been expensed. This is mainly because, when the asset is capitalized, the cost of the asset gets distributed over a number of years (which usually equals the economic life of the asset, and gets reduced from the net income over the period. Whereas, when the asset is expensed, all of its cost is reduced from the net income, in the very first year of its incurring.
b. The sum of the total net income, across the period of the economic life of the asset, remains the same. This is because the total cost that needs to be expensed remains the same, it’s just the timing of expensing the cost that differs.
2. Impact on the Cash Flows
a. The total change in cash over the economic life of the asset would remain the same under both conditions, whether the cost is capitalized or expensed.
b. However, the cash from operations would be lower, if the cost is expensed, than if it is capitalized. This is mainly because when the cost is expensed in the year of incurring then the entire amount is reduced from the cash from operations of that year.
c. The total cash from investing activities over the economic life of the asset would be higher if the cost of the asset is expensed. This is mainly because when the cost is capitalized the entire cost of the asset gets reduced from the ‘cash from investing activities’. Whereas, there is no cash outflow from ‘investing activities’, when the cost is expensed as a current period item.
3. Impact on the Net Worth or Equity
a. The total impact on the change value of net-worth or equity over the economic life of the asset, of the firm, remains the same, whether the asset is capitalized or expensed.
b. But in the initial years, the net worth of the firm would be higher if the asset is capitalized. This is because the net income of the firm is higher when the asset is capitalized. The cost of the asset is distributed and expensed as depreciation or amortization over its economic life, making the income higher in the initial years (than if the cost was all expensed in the year of purchase).
4. Impact on the Figures of Profitability Ratios
a. For the same reasons as discussed above, the figures for return on equity would be higher in the initial year if the asset was capitalized, than if it were to be expensed in the year its cost was incurred.
b. Also, the net profit margin would also be higher in the initial year if the asset was capitalized, than if it were to be expensed in the year its cost was incurred.
We can thus, sum up the impact of capitalizing vs. expensing the cost of an asset through the following table:
|
Capitalizing the Cost |
Expensing the cost |
Net income in Year 1 |
Higher |
Lower |
Net Income in Future Years |
Lower |
Higher |
Total Assets |
Higher |
Lower |
Share Equity in Initial Year |
Higher |
Lower |
Cash from Operation |
Higher |
Lower |
Cash from Investing Activities |
Lower |
Higher |
Income Variability |
Lower |
Higher |
Debt/Equity Ratio |
Lower |
Higher |