Q. A company previously expensed the incremental costs of obtaining a contract. All else being equal, adopting the May 2014 IASB and FASB converged accounting standards on revenue recognition makes the company’s profitability initially appear:
A. lower.
B. unchanged.
C. higher.
C is correct. Under the converged accounting standards, the incremental costs of obtaining a contract and certain costs incurred to fulfill a contract must be capitalized. If a company expensed these incremental costs in the years prior to adopting the converged standards, all else being equal, its profitability will appear higher under the converged standards.
Can someone help me understanding in practical terms how would those expenses be capitalized? I.e.: deducting from expenses, and allocating where?
It’s added to the value of the asset that was improved by the expenses (roughly speaking). Basically, if I repair the roof of a building to such a great extent that the value of the building is improved and it’s longevity is increased in a material manner, it makes sense to “capitalize” these expenses onto the asset value and depreciate them over time since I will see a longer-term benefit than captured by a single period statement. It tries to tie the timing of the cost to the benefit.
Capitalizing a costs mean that that the cost goes onto the balance sheet as an asset instead of on the income statement as an expense. Let’s say that the cost here is $1,000. If capitalized, it would show up on the balance sheet as as long-term asset. Nothing would hit the income statement inititally. Had the cost been expensed, it would show up under the income statement and the $1,000 should reduce net income.
As a simple example, suppose that you buy 1,000 pencils as office supplies. (Y’all remember what pencils are, right? They predate computers.) You’ll probably expense the cost of the pencils, even though your employees may not use all of them this year.
However, if you buy 1,000,000 pencils (Amazon runs a special), then you’ll likely not expense them all at once. You’ll put them on your balance sheet as an asset and expense them over the next few (say, 1,000) years.