I’,m currently doing the CFA Topic Test for FRA and came across a strange situation: In the problem, CCCL was expensing something but they have changed their policy to capitalize it.
Q. The new accounting policy adopted in 2016 for the customer acquisition cost related to long-term wireless contracts (Exhibit 3, Note 1 d) most likely increases CCCL’s:
quality of earnings.
cash from operations.
debt to asset ratio.
I immediately thought the answer was 3. Capitalizing is essentially treated as purchasing an asset financed with debt. So if the company had assets of 100 and debt of 50 before the switch D/A ratio is 50%. With 20 added to both Debt and assets the rate changes to 58.33%.
However, this is not true according to the website. This is their answer “incorrect because the total assets would increase by the amount capitalized (as opposed to expensed) (be higher) hence the D/A ratio would decrease”
I think debt and asset are both increased. This is similar to a operating lease and capitalizing it. However, if debt is > asset, then the ratio decreases… You only tested if the ratio was asset > debt.
You buy a pencil. You might finance it, or you might go wild and pay cash for it. Either way, your debt is established.
Now you have to decide whether you’ll expense it, or capitalize it. If you expense it, your net income (and, therefore, your retained earnings and your equity) will decrease. If you capitalize it, your assets will increase. Note that this decision doesn’t affect your liabilities; they were set in the first paragraph.
Ah yes, the pencil analogy makes sense… I was thinking operating lease vs capital lease but now realize the operating lease is an actual ongoing commitment, while the pencil is not.
S2000, Magician, are you saying both equity and debt will increase by a proportional amount when assets increase, or only equity will increase as retained earnings increases?
When in doubt, dial down down to level 1 chapter long lived assets. The principal that applies is the same. Capitalizing leads to higher income and cfo in the beginning and lower income in the future as against expensing, assuming a positive business environment in the future.
Correct me if I’m wrong, but I believe the opposite is true. Capitalizing leads to lower NI and RE in the near term because the initial interest and amortization costs exceed the annual costs of expensing
Capitalizing leads to higher net income the time a purchased item is capitalized as opposed to expensing it. For example, if I bought an equipment for 100 bucks and record it as an expense on my I/S, it will eat into my income quite a bit. This is called expensing. Whereas, under capitalization if I just record 10 bucks of depreciation (assuming straight line dep) it wont eat into my income as much. But in the next period, the depreciation expense will recur and keep eating into my expense until the asset is totally obsolete. If I had expensed the item, there would be no expense the next period and so on thereby leaving my income unchanged and higher as compared to capitalization of the same.
