A Dist. between costs that are capitalized and costs that are expensed in the period in which they are incurred

Question 1

Capitalized costs

Answer 1

Expenditures are capitalized to the BS as expected future economic benefits over multiple accounting periods

Initially record a capitalized expenditure as an A on the BS @ cost (its fair market value at acquisition + any costs necessary to prepare the asset for use). Then! allocate the cost to the IS over the life of the asset as depreciation expense (when tangible) or amortization (when intangible). Do not depreciate or amort land or acquisition goodwill!)

Capitalization of the long-lived asset then includes capitalization of its subsequent related expenditures that provide future economic benefit, such as rebuilding the asset! However, if the subsequent expenditure merely sustains the usefulness of the asset, as in regular maintenance; operating expenditures, then expense as incurred!

Ex: 205

Capitalize all costs that provide future economic benefits, including costs that are necessary to get the asset ready for use

Initial training costs are expensed because they get the employee’s ready to use the asset, but they don’t get the asset ready for use.

Question 2

Expenses (costs that are expensed in the period in which they are incurred)

Answer 2

Expenditures are expensed to the IS if the expected future economic benefits are unlikely or highly uncertain

Immediate expenditures expension reduces current period pre-tax income by the amount of the expenditure.

Question 3

Distinction between Capitalized Costs and Expenses…

Answer 3

…has to do with the likelihood or certainty of and expenditure providing future economic benefits over multiple accounting periods.

Question 4

Capitalization or Expense will affect…

Answer 4

NI, SE, CFO, Financial Ratios, Capitalized Interest

Question 5

Long-Lived asset cost recognition and NI

Answer 5

In the LR (over the life of an asset) Total Net Income is the same, except for timing…capitalzied costs are timed through multiple periods and depreciated, expenses are not depreciated.

Capitalizing an expenditure delays the recognition of an expense in the income statement which means a higher NI initially but lower through the allocation of the cost, or depreciation. Depreciation reduces the variability of NI by spreading the expense over multiple periods.

Expenditures that are expensed in the current period reduce NI by the after tax amount of the expenditure, but no depreciation takes place so that future subsequent NI is higher, where the expenditure is expensed.

Question 6

Long-Lived asset cost recognition and SE

Answer 6

So, capitalization results in higher NI in the period of the expenditure compared to expensing, thus also results in higher SE becausssssse RE (RE = A - L) are greater!!! However, as the costs are allocated or rather, depreciated, NI, RE, and SE are reduced.

However, if the expenditure is immediately expensed, NI>RE>SE reflect the entire reduction in NI in the period of the expenditure.

Question 7

Long-Lived asset cost recognition and CFO

Answer 7

Capitalized expenditures on the CF’s are reported as Outflows from investing activities, but if immediately expensed, then it is reported as an outflow from operating activities.

So, Capitalizing a cost will result in higher operating CF and lower investment cash flow compared to expensing.

Total cash flow will be the same, assuming no differences in tax treatment. That is because depreciation, which is a NONCASH EXPENSE, does not affect operating CF

Question 8

Long-Lived asset cost recognition and Financial Ratios

Answer 8

Debt to assets and debt to equity ratios are lower with capitaliztion, because capitalization results in higher assets and higher equity compared to expensing

Will initially result in higher ROA and higher ROE due to capitalizations increase NI effect in the year recognized…however, through time these ratios will be lower because of depreciation. Compared to expenses, which are recognized in the first year where ROA and ROE are lower initially but higher in subsequent years.

Question 9

Long-Lived asset cost recognition and Capitalized Interest

Answer 9

The interest that accrues during the construction period of an asset for a firms own use, or resale, is capitalized during the construction period as part of the assets costs, in order to accurately measure the cost of the asset and to better match the cost with the revenues generated by the constructed asset.

The ‘r’ used to capitalize interest is the ‘r’ on the debt related to the construction of the asset. However, if no debt is outstanding, then base ‘r’ on existing unrelated borrowings. Only interest on the construction costs is capitalized.

Interest costs are EXPENSED on general corporate debt in excess of project construction costs.

Capitalized int. is not reported as int. in the income statement as interest expense. instead it is allocated to the IS through depreciation expense (if the asset is held for use), or COGS (if the asset is held for sale)

Capitalized interest and CF’s - outflow from investing activities

interest expense and CF’s - Outflow from Operating activities

However, IFRS reports int. exp. on CF’s as either operating or financing.

Capitalizing interest results in lower interest expense compared to expensing so a firms ability to make required interest payments on it’s debt seems higher; known as the interest coverage ratio (EBIT / Interest Expense) when interest is capitalized.

So, adjust as an analyst by treating the capitalized interest as interest expense for analytical purposes to reduce the interest coverage ratio.