CFA Practice Question

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CFA Practice Question

If a firm decides to capitalize rather than expense the cost of assets, this will mean the return on assets will be ______

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

Capitalization will lead to higher reported assets, which 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.

User Contributed Comments 11

User Comment
kamin who can explain??
proquo When u capitalize the cost of asset, u put the asset on the balance sheet unlike in the case of expensing it. Thus, the assets are higher which implies lower returns on assets - the denominator is higher.
When u capitalize the cost of asset in a given period u show only part of the whole cost to be deducted from revenue which has relatively lower effect on the earnings in this period, i.e. earnings change in a smother way - they are less volatile than if u deduct the whole cost in one period.
coolnan Thanks proquo! very good!
ramani the study material is extremely useful.Many Thanks.
kutta2102 I don't understand the second part - how will the longer term ROA be lower? Is it because you'd have a higher average-asset-value on your BS for a longer period of time?
viannie Kutta2102: Yes, assets will increase due to capitalization. Assets will be in the balance sheet. So as the denominator of ROA increases, ROA decreases. Assets will not be removed unless sold...long term assets will be ultilized by the firm to generate economic profits. hope that helps ;)
aravinda One more thing is the long term, due to continued depreciation of capitalized amount, netincome will be lower..
ROA = NI/Net Assets....decrease in numerator and increase in denominator....resulting in lower ROA in the long term.
Ifi2703 Thanks, Aravinda - makes sense!
gill15 Where my confusion is that ROA = NI / Assets. I understand capitalizing will cause Assets to be greater then if expensed but NI will also be greater for a capitalized item compared to an expensed item. Therefor both numerator and denominator increase. Whats going on?
gill15 Aravinda -- regarding my last post...LONG TERM...nice. good fix retrospectively for posts before I write a post...done
maryprz14 When a cost is capitalized means that specific asset account increases in value. my confusion is how about the cost of it? what if the cost is paid in cash? then cash account would decrease and on the balance sheet, the total assets will not change right?
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