Hey,
If you choose to capitalize a cost how dose that effect the balance sheet?
Exapmle:
Lets say you buy a machine for 20.000 and capitalize it over 10 years, how will that effect the asset side and the liability and equity side in the initial year, and also in the subsequent years?
Also, what will the effects be on the income statenent and on the cash flow statements?
When you are talking about capitalizng a cost, it would usually refer to the capitalization of an expense. Capital costs like the purchase of a machine are meant to be capitalized and carried on the balance sheet.
On he other hand, if you have spent $100,000 on corporate travel and instead of expensing it in the income statement, you chose to carry it as an asset to be amortized over 5 years (say under other assets - an ambiguous category). Your depreciation/amortization costs are going to increase in the coming years without a commensurate increase in your fixed (and productive assets).
Ratios related to assets will also be affected (Asset Turnover e.t.c.)
Liabilities won’t be affected.
Equity will be higher when you capitalize than when you expense, until the capitalized asset is depreciated/amortized fully.
Liabilities would only be unaffected if purchasing the machine with cash, correct?
This always throws me off, because I always assume a large purchase will be made using debt, but it’s rarely specified. \
And wouldn’t net income be higher in the first year when capitalizing, then higher for expensing in later years because it would only affect the period incurred?
E.g.:
1 2 3
Depr. 500 500 500
Exp. 1500 0 0
Thank you for the reply. What exactley is happening on the Equity side? My understanding is that the depreciation is added to the asset side, what is happening in the equity side to match this? Both in year 0, the following year and the last year of the 10y period.
Thank you very much. Are you able to show this in an example?
Could someone explain what exactly is happening on the Equity side?
If you expense, you have the following transactions:
Dr Expense for machine 10,000 / Cr Payable or Cash 10,000 (if it’s Payable, then when you pay you have Dr Payable / Cr Cash also)
At year end, closing operation:
Dr Equity 10,000 / Cr Expense 10,000
If you capitalize, you have the following:
Dr Asset 10,000 / Cr Payable or Cash 10,000 (if it’s Payable, then when you pay you have Dr Payable / Cr Cash as well, same as above)
Dr Depreciation Expense 1,000 / Cr Accumulated depreciation 1,000 (a contra-asset account; assuming 10 year useful life of machine, and capitalization at 1 Jan, so full year of depreciation expense is charged)
At year end, closing operation:
Dr Equity 1,000 / Cr Expense 1,000
Equity side is higher with capitalizing in year 0 than expensing in year 0.
Equity side is higher in each subsequent year after year 0 with expensing because entire expense amount was booked only in year 0 and equity is lower in subsequent years due to a depreciation expense at capitalization method.
That’s correct only if you purchase an asset and create a CAPEX by your own cash what is a rare situation, IMO and is not recommended.
More common is creating a CAPEX by using debt, governmental incentives or issuing additional stock.
It appears that you misunderstood my post.
What I meant was that liabilities won’t be affected by the decision to expense versus capitalize. Of course, liabilities would increase if you finance the purchase, but the amount is the same in either case.
If so, I’m sorry. However, Excess expense capitalization will make up the BS and make the company more attractive in the eyes of the debtor, thus capitalization will affect A/L ratio differently related to ordinary expensing. Regarding cash flow expenditure, it’s a same cash amount spent but may be more creatively classified in the CF statement. What I want to say, no matter same amount of cash was spent, by various accounting makeover, 2+2 may not be 4.
Equity side of the BS includes retained earnings.
If you capitalize an expense, the net income is increased by expense*(1 - tax), so does the retained earnings and equity.