Subject 1. Capitalizing versus Expensing

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. All costs incurred until an asset is ready for use must be capitalized, including the invoice price, applicable sales tax, freight and insurance costs incurred delivering equipment, and any installation costs. Costs of the 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.

Accounting rules on capitalization are not straightforward. As a result, management has considerable discretion in making decisions such as whether to capitalize or expense the cost of an asset, whether to include interest costs incurred during construction in the capitalized cost, and what types of costs to capitalize for intangible assets. The choice of capitalization or expensing affects the balance sheet, income and cash flow statements, and ratios both in the year the choice is made and over the life of the asset.

Here is a summary of the different effects of capitalization versus expensing:

  • Income variability. 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.

  • 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. This results in higher ROA and ROE because these expensing firms report lower assets and equity.

  • CFO. The 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.

  • Leverage ratios. Capitalization firms have better (lower) debt-to-equity and debt-to-assets ratios, since they report higher assets and equities.

Under SFAS 34, interest is capitalized for certain assets and only if the firm is leveraged. Therefore, the carrying amount of a self-constructed asset depends on the firm's financial decisions. The capitalized interest cost is added to the value of the asset being constructed.

The amount of interest cost to be capitalized has two components:

  • Any interest on borrowed funds made specifically to finance the construction of the asset. The interest rate applicable is the interest rate on each borrowing.
  • The interest on other debt of the firm, up to the amount invested in the construction project. The interest rate applicable is the weighted-average interest rate on all outstanding debt not specifically borrowed for the asset under construction.

Therefore, the total interest cost incurred during the accounting period has two parts:

  • Capitalized interest cost, which is reported as part of the asset on the balance sheet. Payments for capitalized interest cost are classified as an investing cash outflow and never as CFO.
  • Other interest cost, which is charged to expense on the income statement. Payments for such non-capitalized interest cost are reported as CFO.

The total interest cost, along with the amount capitalized, must be disclosed as part of the notes to the financial statements.

Once the construction is complete, capitalized interest costs will be written off as part of depreciation over the useful life of the asset. From now on, any future interest cost on remaining borrowings made for the construction of the asset must be expensed.

For analytical and adjustment purposes, analysts probably need to expense all interest in self-constructed assets (that is, the income statement capitalization of interest should be reversed).

During the construction period this could result in:

  • Lower fixed and total assets, as the capitalized interest would be converted to interest expense.
  • Lower net income, as the interest expense would be higher.
  • Lower CFO and higher CFI as payments for capitalized interest would be classified as investing cash flows and be reversed to be operating cash flows.
  • Lower interest coverage ratio, as the adjustment would produce lower earnings before interest and tax but higher interest expense.
  • The same net cash flows, as capitalization and expensing are accounting adjustments only. They don't affect net cash flows.

During the useful life of the asset this could result in:

  • Higher net income, due to a lower depreciation amount.
  • The same interest, as all interest costs would be expensed.
  • A higher interest coverage ratio, due to higher earnings before interest and tax (same interest expense).

User Contributed Comments 13

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sjchen: Shouldn't net income be higher during construction period since part of the interest expenses will be capitalized and reported as assets?
MFTIOA: "Lower interest coverage ratio as the adjustment would produce lower earnings before interest and tax but higher interest expense."

Why would EBIT be lower?
clafleur: sjchen and MFTIOA, it is saying that net income will be lower when you reverse the capitalization of interest and expense it because there will be a higher interest expense, thus lower NI.
miiyeung: CAPITALIZED EXPENDITURE:

1) CAPITALIZE ASSET ON BS
VS.
2) EXPENSE COST ON IS

PER ABOVE:
1) INTEREST COST is CAPITALIZED INTEREST -> CFI OUTFLOW

2) report as CFO -> INTEREST COST IS EITHER A) DEPRECIATION EXPENSE (using asset) OR B) COGS (selling asset)
soorajiyer: @sjchen - I think You are right, the notes is talking what happens when the capitalization of interest is reversed by an analyst!
bhaynes: soorajyer/sjchen/MFTIOA - I think you all miht be mistaken. The last part of the notes in thie section are referring explicitly to a SELF-constructed asseet. In the cash the asset is self-constructed, the interest should not be capitalized.

Net Income will be lower since you have higher expenses.

Interest Coverage (EBIT/Interest Expense) is lower since your earnings are lower and the and interest expense is higher.
Mgtw: How come for self-constructed assets interest is not capitalized? (or at least not useful for analysis to capitalized interest?)
teje: going from capitalized interest to expensed interest, if we are considering an asset for use (which is also self-constructed)...obviously interest expense will rise. However, I think EBIT should go up, as the capitalized interest previously flowed through the depreciation expense (asset for use), but since we are now expensing this interest cost, we should add back this amount to EBIT. Because the interst expense is greater than the increase in EBIT, interest coverage ratio still declines. Remember depreciation is netted out to arrive at EBIT.
ascruggs92: clafleur, he is referring to the part that specifically says "adjustments would produce lower earnings before interest and tax (EBIT) but higher interest expense." However, EBIT is, by definition, not effected by changes in interest expense. That statement is incorrect.
guest: First time I find the "AN subjects organization" vs "other close CFA materials" quite inappropriate (had to wait the 30th reading, it's reassuring).The early and thorough focus on interest treatment creates more confusions than clarifications in view of the principal issues of long-lived assets and capitalization vs expenses.
starbucks: The textbooks are organized around subjects too, not around LOSes. I think it's more appropriate.
Memeteau: Agree with you Starbucks (I was the "guest" ;-)). Perhaps I was not clear. I was just trying to underline that the specific "AN subjects organization of that reading 30 as a whole" is not their greatest masterpiece.
domedome: thank you teje