CFA Practice Question

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CFA Practice Question

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
Explanation: Statement 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; had the items been fully expensed in the initial year, there would not have been any more recorded expenses.

Statement IV is incorrect because firms that expense costs rather than capitalizing them will report lower assets, and therefore lower equity values. Consequently, the debt-to-equity ratio will be higher for a company that expenses the costs in question.

User Contributed Comments 4

User Comment
labsbamb Not too sure about IV incorrect, because when expensing cost:
Higher interest expense
Lower depreciation
Higher ebit
Lower asset
lower interest coverage (interest expense high)
CFO lower
CFI higher
Why IV is incorrect?
dealsoutlook IV should be incorrect since when expensing you have lower assets and therefore lower equity leading to higher debt to equity ratio. I think that makes sense
Xocrevilo Yes, when expensing, the D-E ratio may be higher, but the absolute value of debt might be much lower, all else equal.
CJPerugini These questions piss me off sometimes. Throughout the period means THIS period, not in subsequent periods to come.
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