115 CFA
File: - Financial Analysis - Reading 26 - 1. Capitalizing versus Expensing

1. Capitalizing versus Expensing

a. distinguish between costs that are capitalised and costs that are expensed in the period in which they are incurred;

c. explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios;

When should something be capitalized?
The costs of acquiring resources that provide services over more than one operating cycle should be capitalized and carried as assets on the balance sheet.

What is the accounting difference between expense vs capitalization?
Costs of the capitalized long-lived asset should be allocated over current and future periods. In contrast, if these assets are expensed, their entire costs are written off as expense on the income statement in the current period.

What are four different effects of capitalization vs expensing?
1. Income variability
2. Profitability
3. CFO (Cash Flow from Operations)
4. Leverage ratios

How does capitalization impact a company's pattern of income? How does it impact those that expense those costs?
Firms that capitalize costs and depreciate them over time show "smoother" patterns of reported income. Firms that expense those costs as incurred tend to have higher variability of net income.

How does capitalization vs expensing impact profitability?
In the early years expensing lowers profitability because the entire cost of the asset is expensed. In later years expensing results in higher net income because no more expense is charged in those years.

How is Cash Flow from Operations (CFO) impacted by capitalization vs expensing?
Net cash flow remains the same, but the compositions of cash flows differ. Cash expenditures for capitalized assets are included in investing cash flows and are never classified as CFO. In contrast, cash expenditures for expensed outlays are included in CFO and are never classified as investing cash flows. Capitalization results in higher CFO but lower investing cash flows, and the cumulative difference increases over time.

How is ROE and ROA impacted differently by capitalizing vs expensing?
Companies that expense show lower profitability up front, but higher ROE and ROA later because they don't carry assets on the balance sheet.

How are leverage ratios impacted by capitalization vs expensing?
Capitalization firms have better (lower) debt-to-equity and debt-to-assets ratios, since they report higher assets and equities.

What is SFAS 34?
Under SFAS 34, interest is capitalized for certain assets and only if the firm is leveraged.

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