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 the asset is ready for use must be capitalized, including the invoice price, applicable sales tax, freight and insurance costs incurred delivering the 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 in the income statement in the current period.

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:

  • 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 never classified as CFO. In contrast, cash expenditures for expensed outlays are included in CFO and 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.

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:

  • 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 in the income statement. Payments for such noncapitalized 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.

For analytical and adjustment purposes, if an analyst needs to expense all interest costs, this could result in (during the construction period):

  • 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.
  • 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 lower depreciation amount.
  • Same interest as all interest costs would be expensed.
  • Higher interest coverage ratio due to higher earnings before interest and tax (same interest expense).

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.

Practice Question 1

If a firm decides to capitalize rather than to expense the cost of assets this will mean:

A. the return on assets will be more volatile and in the long term the return on assets will be lower.
B. the return on assets will be less volatile and in the long term the return on assets will be higher.
C. the return on assets will be less volatile and in the long term the return on assets will be lower.
Correct Answer: C

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.

Practice Question 2

A company is considering making material adaptations to its warehouse and equipment. These costs will be $25,000,000 and will have a benefit period of 10 years. The income tax rate during this period will be 30%. The company is considering the effects of capitalizing the costs using straight-line depreciation versus expensing the cost. Assuming the costs are expensed, in the first year:

I. cash flows will be higher by $6,750,000 than if the costs were capitalized.
II. debt-to-equity ratios will be higher if the costs are expensed.
III. debt-to-assets ratios will be higher if the costs are expensed.
Correct Answer: I, II and III

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.

Practice Question 3

Capitalizing an expenditure rather than expensing it results in:

I. Greater amounts reported as cash from operations.
II. Lower profitability ratios in the early years.
III. Greater shareholders' equity in the early years.
Correct Answer: I and III

It results in higher profitability ratios in the early years.

Practice Question 4

The amount of interest that may be capitalized under GAAP is:

A. Actual interest
B. The lower of actual interest or avoidable interest
C. Imputed interest
Correct Answer: B

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.

Practice Question 5

The SFAS No. 34 requirement relating to capitalization of interest costs incurred on self-construction results in immediate company tax advantages. True or False?
Correct Answer: False

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.

Practice Question 6

Ashley Corporation constructed an office building for its own use. During 2011, the average accumulated expenditure for construction was $4,000,000. At the end of 2010, Ashley had borrowed $1,000,000 specifically for the construction costs. The interest on the construction loan was 11%. The only other debt was $10,000,000 debentures (outstanding all of 2011), with an interest rate of 8%. How much is the interest to be paid in 2011?

A. $110,000
B. $800,000
C. $910,000
Correct Answer: C

The total interest = ($10,000,000 x .08) + ($1,000,000 x .11) = $800,000 + $110,000 = $910,000.

Practice Question 7

The capitalization of interest distorts all of the following except:

A. interest coverage ratio.
B. cash flows from operations.
C. net income.
D. change in cash during period.
Correct Answer: D

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.

Practice Question 8

Select the correct statement(s):

I. Capitalized interest appears as part of investing cash inflows.
II. Expensed interest reduces operating cash flows.
III. Analysts should include capitalized interest when calculating a firm's interest coverage ratios.
Correct Answer: II and III

I: Capitalized interest appears as part of investing cash outflows, not inflows.

Practice Question 9

A company is considering making material adaptations to its warehouse and equipment. These costs will be $25,000,000 and will have a benefit period of 10 years. The income tax rate during this period will be 30%. The company is considering the effects of capitalizing the costs versus expensing the cost. In year one, which of the following would be true concerning post-tax income?

A. The expensing would cause $25,000,000 less in net income.
B. The expensing would have $22,500,000 less in net income.
C. The expensing would cause $15,750,000 less in net income.
Correct Answer: C

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.

Practice Question 10

A company is considering making material adaptations to its warehouse and equipment. These costs will be $25,000,000 and will have a benefit period of 10 years. The income tax rate during this period will be 30%. The company is considering the effects of capitalizing the costs versus expensing the cost. Which of the following statements would be true?

I. If costs are capitalized, cash flows in years 2-10 will be higher by $750,000.
II. If costs are expensed, cash flows in years 2-10 will be higher by $750,000.
III. If costs are capitalized, there will be a smoother pattern of income over the life of the project.

A. I, II and III
B. II and III
C. I and III
Correct Answer: C

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.

Practice Question 11

A company is considering making material adaptations to its warehouse and equipment. These costs will be $25,000,000 and will have a benefit period of 10 years. The income tax rate during this period will be 30%. The company is considering the effects of capitalizing the costs versus expensing the cost. Which of the following effects will occur if the costs are expensed rather than capitalized?

A. Expensing will cause income to be greater in the years after the first year by $1,750,000 per year.
B. Expensing will cause the return on assets in later years to be lower.
C. Expensing will cause the return on equity to be lower in later years.
Correct Answer: A

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.

Practice Question 12

Which of the following would be an effect of capitalizing interest costs?

I. Depreciation is understated.
II. Interest coverage would be understated.
III. Cash flows from investing are understated.
IV. Cash flows from operations are understated.

A. I, II and III
B. III only
C. II and IV
Correct Answer: B

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.

Practice Question 13

Ashley Corporation constructed an office building for its own use. During 2010, the average accumulated expenditure for construction was $4,000,000. At the end of 2009, Ashley had borrowed $1,000,000 specifically for the construction costs. The interest on the construction loan was 11%. The only other debt was $10,000,000 debentures (outstanding all of 2010), with an interest rate of 8%. What are the amounts of interest to be capitalized in 2010 and expensed in 2010?

A. $440,000 and $110,000
B. $350,000 and $560,000
C. $110,000 and $800,000
Correct Answer: B

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.

Practice Question 14

Which of the following would an analyst need to adjust due to the capitalization of interest (assume U.S. GAAP)?

A. cash flows from operations
B. cash flows from financing
C. current ratio
Correct Answer: A

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.

Practice Question 15

Reclassification of capitalized interest as an expense will have the following balance sheet effect:

A. Reduction in shareholders' equity by the product of the change in capitalized interest and (1 - Tax rate).
B. Decrease in deferred tax liability by the change in capitalized interest.
C. Reduction in capitalized asset by the product of (1 - Tax rate) and capitalized interest adjustment.
Correct Answer: A

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,

Reduction in shareholders' equity = (1 - Tax rate) x Capitalized interest

Practice Question 16

Which of the following statements is (are) true with respect to the impact the choice between expensing and capitalizing will have on certain financial ratios?

I. Profit margins will be higher throughout the period for firms that capitalize certain expenditures as opposed to expensing them.
II. Reported income tends to be more stabilized throughout the period if the capitalization method is used.
III. Asset turnover ratios will be lower for firms that capitalize certain expenditures as opposed to expensing them.
IV. Debt-to-equity ratios will be lower for companies that expense costs as opposed to capitalizing them.

A. I and II
B. III and IV
C. II and III
Correct Answer: C

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.

Practice Question 17

Which of the following statements is (are) true with respect to the impact that the capitalization of interest will have on certain financial ratios?

I. Interest coverage ratios will increase.
II. Accounting income will increase relative to cash flow.
III. Current ratio will increase.
IV. Asset turnover ratios will increase.

A. I and II
B. II and III only
C. I, III and IV
Correct Answer: A

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.