Adjustments for Capitalizing Vs Expensing

CFA Level II
#1

How do we adjust for cashflow from operations when adjusting capitalized statements to expensed?

I understand that we need to remove the capitalized interest cost from CFO but should this be removed after tax?

Any help or thoughts will be very much appreciated. Thanks

#2

Pre-tax

#3

Thanks for your help verse214!!!

I saw this was the case in the CFAI text, but i can’t seem to understand why.

My understanding is that if we assumed that the capitalized costs had been included in Interest expense as opposed to being capitalized, this would have increased the amount of Interest we have to pay and as a result provided some cash savings from tax.

Additionally, every other item in operating cashflow are carried net of taxes, why should this be different?

I would really appreciate some thoughts

#4

I think if you move from capitalising to expensing, CFI will increase, CFO will decrease but the *total cash flows remain unchanged*. The capitalised interests recorded in the CFI didn’t go through Income Statement and therefore is “pre-tax” and the ensuing downward adjustment to CFO is pre-tax too in the Cash Flow Statement context.

In the context of Income Statement, NI will be lower by (interest expense * 1-T) if you expense it, and since CFO = NI + NCC - change in WC, CFO will be lower by interest expenese net of tax as you realise the tax shield from deductable expenses in the current year as opposed to future years under caplitalising

In the current year, I see there is a mismatch from different approaches…I’m not quite sure then.

#5

@Xander086 you add the pre-tax interest expense to the current interest expense right when you calculate the interest coverage ratio? And in order to adjust the EBIT you just subtract rental expense minus depn?

Thank you.

#6

What about the depreciation tax shield?

#7

(1) When you move from capitalising to expensing, interest coverage ratio:

Numerator EBIT = unchanged (ignoring depreciation)

Demoninator Interest Expense = increased by pre-tax amount since interest expense is always before “the line”

Thus, the ratio decrease.

(2) When you move from operating lease to capital lease,

Numerator = EBIT + Rental - Depreciation

Demoninator = Int. Exp. + Increased pre-tax interest expense

#8

Xander can you summerize all kind of possible adjustment in FRA? U have listed capitalize to expensing , operating to finacial lease, what abt asset revaluation, … Is there anything else that i missed?