Reading 30 - Capitalization of long term assets

CFA Level I FRA
#1

1 Why does capitalization of a long lived asset increase CFO and decrease CFI by the same amount?

2 Why does capitalization of interest expense do the opposite? i.e. increase CFI and decrease CFO?

#2

  1. When you purchase a long-lived asset you can either expense it right away or capitalize it. When you capitalize it, it is consider as an investing cash flow. When you expense it it is consider a operating cash flow. That is why many companies would prefer to capitalize in order to ‘‘increase’’ CFO and ‘‘decrease’’ CFI.

  2. When you capitalize interest you will need to depreciate the interest as if it would be a depreciable asset. The depreciation charge will automatically decrease your CFO. On the other hand, if interest is not capitalized it would be like an CFI outflow since interest payment is considered as being a CFI and not a CFO. When a company built a long-lived asset for its own use, the interest expense will be depreciated with the total value of the asset. When the company builds the long lived asset for another entity, the capitalized interest will be part of COGS when revenue is recognized.

Anyone, correct me if I am wrong. It has been a while since I studied FRA.

#3

  1. You said “When you capitalize it, it is consider as an investing cash flow.” but then why does CFO increase?

  2. Why is is the opposite for capitalized interest?

#4

i would say that it doesnt “increase” CFO, so much as that it doesn’t decrease it. anyone care to comment?

#5

pdub is right, it does neither decreases nor increases CFO. Capitalizing an asset only affects CFI because it is considered as an investing activity and not an operating activity. There will be subsequent CFO in the form of depreciation charges, but that is it.

#6

Holding all variables constant (ceteris paribus ha ha), that’s why it’s referred to as “increase” and “decrease”. But you are right.

#7

The second statement is wrong. Capitalization of interest expense (or any expense for that matter), will increase CFO (because its not part of Net income anymore) and decrease CFI (since it treated as an investment viz PPE).

The statement given above is the opposite- increase CFI and decrease CFO. That’s not possible.