Capitalizing vs Expensing – Effects on Ratios

Discretion regarding whether to expense or capitalize expenditures can impede comparability across companies. For example, a company that expenses its expenditure instead of capitalizing it will have lower profitability in the first year but higher profitability in subsequent years, indicating a favorable trend. Similarly, the shareholders’ equity for a company that capitalizes on expenditure will be higher in the earlier years because initially higher profits will result in higher retained earnings.

Capitalizing the expenditure also results in greater amounts being reported as cash from operating activities. It is important to note that cash flow from operations is such an important consideration in some valuation models that companies may try to maximize reported cash flow from operations. They do this by capitalizing expenditures that should be expensed.

Capitalizing

During the period of expenditure, an expenditure that is capitalized will increase the amount of assets reported on the balance sheet and will appear as an investing cash outflow on the statement of cash flows. In subsequent periods, the company will allocate the capitalized amount over the asset’s useful life as depreciation or amortization expense. This expense will reduce the net income on the income statement. Aside from this, it will reduce the value of the asset reported on the balance sheet. Depreciation and amortization expenses are non-cash in nature and therefore, apart from their effect on taxable income and taxes payable, have no impact on the cash flow statement.

Therefore, capitalizing an item of expenditure will enhance current profitability and increase reported cash flow from operations. This profitability-enhancing effect will continue as long as capital expenditures exceed the depreciation expense. Profitability-enhancing motivations for decisions to capitalize should, therefore, be considered when analyzing a company’s financial performance.

Expensing

Alternatively, during the period of expenditure, an expenditure that is expensed will reduce net income by the after-tax amount of the expenditure. No asset will be recorded on the balance sheet and therefore, no depreciation or amortization will occur in subsequent periods. The lower amount of net income is reflected in lower retained earnings on the balance sheet. The expense will appear as an operating cash outflow in the period in which it is made, and there will be no effect on the financial statements of subsequent periods.

Expensing a cost in the current period will reduce current period profits but enhance future profitability and the profit trend. Profit trend-enhancing motivations should, therefore, be considered when analyzing financial performance.

Question 1

Which of the following statements is least accurate?

1. Expensing reduces current period profits but enhances future profitability.
2. Capitalizing decreases the amount of assets reported on the balance sheet.
3. Capitalizing an expenditure enhances current profitability and increases reported cash flow from operations.

Solution

The correct answer is B.

Capitalising will increase, not decrease, the amount of assets reported on the balance sheet. Both statements A and B are accurate.