Accounting rules on capitalization are not straightforward. As a result, management have 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:
Capitalization of Interest Costs
Interest costs related to long-lived assets should generally be capitalized as part of the assets on the balance sheet. Capitalized interest costs will be written off as part of depreciation over the useful life of the asset.
The total interest cost incurred during a accounting period has two parts:
The total interest cost, along with the amount capitalized, must be disclosed as part of the notes to the financial statements.
For analytical and adjustment purposes, if an analyst needs to expense all interest costs, this could result in (during the construction period):
During the useful life of the asset this could result in:
Capitalization of Internal Development Costs
For internally generated intangible assets, it is difficult to measure costs, benefits and economic lives. Generally, internal generated assets, such as costs of R&D, patents and copyrights, brands and trademarks, advertising and secret processes must be expensed in the period incurred.
One exception is research and development (R&D) expenditures which are risking investment with uncertainty future economic benefits. As a result they must be expensed as incurred in most countries (including the U.S.). SFAS 86 requires that all R&D costs to establish the technological and/or economic feasibility of the software must be expensed. Subsequent costs that beyond the point of technological feasibility can be, but don't have to be, capitalized as part of product inventory and amortized based on revenues or on a straight-line basis. The point of technological feasibility is the point in the process where the software prototype has been proved to be technologically feasible, as evidenced by the existence of a working model of the software.
IFRS also requires research costs be expensed but allows development costs to be capitalized under certain conditions.
As you can see, managers have considerable discretion in making decisions such as whether or when to capitalize these costs and by how much. For software development costs, one particular risk is that these capitalized costs will not be realized and a future write-down may be needed.
If companies apply different approaches to capitalizing software development costs, adjustments can be made to make the two comparable.
A. the return on assets will be more volatile and in the long term the return on assets will be lower.
Capitalization will lead to higher reported assets that will increase the denominator of return on assets. Earnings will be less volatile than if assets were expensed. Expensing would lead to large fluctuations in earnings.
I. cash flows will be higher by $6,750,000 than if the costs were capitalized.
Expenses relating to the costs of the adaptation would be $25,000,000 in the first year if the costs are expensed, whereas they would be $2,500,000 ($25,000,000/10) in the first year if the costs are capitalized. The expensing would cause $22,500,000 ($25,000,000 - $2,500,000) more in expenses. This would cause a difference in taxes paid of $6,750,000 ($22,500,000 x 0.3). The expensing would cause fewer taxes to be paid. The debt-to-equity ratio would be higher under expensing, because the income is lower, making the equity lower. The assets will be lower, causing the debt-to-assets ratio to be higher.
I. Greater amounts reported as cash from operations.
It results in higher profitability ratios in the early years.
A. Actual interest
Avoidable interest is computed even if the firm used financing other than debt for the project. The rationale is that if the firm had not engaged in the project, it would have used the non-debt financing to pay down debt. GAAP limits the capitalization of interest to the avoidable amount if it less than actual costs incurred.
To minimize income tax payments, a firm would want to expense the interest costs immediately rather than capitalize them and receive the tax benefit later in the form of greater depreciation expense.
The total interest = ($10,000,000 x .08) + ($1,000,000 x .11) = $800,000 + $110,000 = $910,000.
A. interest coverage ratio.
Because interest is capitalized, interest expense is understated, which would distort the interest coverage ratio. Cash flows from operations would be understated because part of the interest is included in the cash flows from investing activities. Net income would be too high, because not all of the interest is included in calculating income.
I. Capitalized interest appears as part of investing cash inflows.
I: Capitalized interest appears as part of investing cash outflows, not inflows.
A. The expensing would cause $25,000,000 less in net income.
In the first year, expenses would be $25,000,000 if the costs were expensed. If costs were capitalized, expenses would be $2,500,000 ($25,000,000/10). The difference in the expenses is $22,500,000, before the tax effect, and $15,750,000 after taxes ($22,500,000 x .7). If the costs were expensed in the first year, net income would be $15,750,000 less.
I. If costs are capitalized, cash flows in years 2-10 will be higher by $750,000.
A. I, II and III
In the second year and years following, there are no associated expenses if the costs are expensed in the first year. If the costs are capitalized, there are depreciation expenses of $2,500,000 that will improve cash flow by decreasing the taxes by $750,000 =($2,500,000 x .3). If the costs are capitalized, the expense in each of years 1-10 will be the same--the depreciation expense of $2,500,000.
A. Expensing will cause income to be greater in the years after the first year by $1,750,000 per year.
In the years following the year the costs were incurred, there will be no expense if the costs were expensed in the first year. However, if costs were capitalized, there would be a $2,500,000 depreciation cost, which, after the tax effects (.3 x $2,500,000), would make income less by $1,750,000.
I. Depreciation is understated.
A. I, II and III
Depreciation is overstated (interest is included in the cost of the asset); interest coverage is overstated (interest expense is too low); and cash flows from operations are overstated (not enough interest has been deducted). Cash flows from investing are understated, as the interest expense has been included in the cost of the asset.
A. $440,000 and $110,000
The amount of interest to be capitalized cannot exceed the appropriate interest rates multiplied by the average accumulated expenditures for construction. It is to be applied first using any specific borrowing. The interest capitalized would be ($1,000,000 x .11) + ($3,000,000 x .08) = $110,000 + $240,000 = $350,000. The amount to be expensed would be the remainder of the total interest of $910,000, which is $560,000.
A. cash flows from operations
Cash flows from financing, the current ratio and quick ratio are not affected by the inclusion of interest in the cost of assets. Cash flows from operations would need to be adjusted by a reduction in the amount of the interest capitalized.
A. Reduction in shareholders' equity by the product of the change in capitalized interest and (1 - Tax rate).
By treating capitalized interest as an expense, net income will be reduced by the amount of capitalized interest with a tax saving of the capitalized interest multiplied by the tax rate. The net is given by,
I. Profit margins will be higher throughout the period for firms that capitalize certain expenditures as opposed to expensing them.
A. I and II
I is incorrect. It is true that in the early years, profits will be higher when certain expenses are capitalized. However, in the following years, a capitalized method would still report an annual expense; but had the items been fully expensed in the initial year, there would not have been any more recorded expenses.
IV is incorrect because firms that expense costs rather than capitalizing them, will report lower asset, and therefore, lower equity values. Consequently, the debt-to-equity ratio will be higher for a company that expenses the costs in question.
I. Interest coverage ratios will increase.
A. I and II
III is incorrect because capitalized interest will be a part of long term assets rather than current assets.
IV is not correct because capitalized interest will inflate asset values, causing the asset turnover ratio to actually drop.