FRA is really my weak area, same in Level 1, so I need greater minds to help me again: In Example 4 capitalizing vs expensing there is a section on adjusting P/E (a similar question shows up on the 2013 mock) it’s describe how $6000 expensing software dev cost reduce Net Income. Then it describes that previously capitalized dev cost is amortized at $2000 and when switching to expensing, this needs to be added back, this is what I have a hard time understanding. If you inflate Net Income over several years by capitalizing instead of expensing dev cost how can you move back to expensing with just expensing the last years dev cost and adding back 1 years amortization. What about all the previous years when you capitalized instead of expensed? As an example if you over 3 years, each year capitalized $6000 of dev cost and amortized $2000 the following year, after 3 years you have total of 6+6+6-2-2=14k of capitalized dev cost. If you move to expensing, shouldn’t all these 14 000 be expensed? Anyone who can clarify, please do!
The $2,000 in amortization covers all previous years that you capitalized, not just last year. If you amortize over, say, 10 years, then that $2,000 includes a portion of the capitalized costs for each of the last 10 years.
You don’t need to worry about the remainder of the capitalized costs from previous years; if you expensed instead of capitalizing, those costs would have affected previous years’ net income, not this year’s net income.
This year’s $6,000 would be deducted on this year’s income statement.
Last year’s $6,000 would have been deducted on last year’s income statement; the only portion that would affect this year’s is the amortization (part of the $2,000 of this year’s amortization).
The $6,000 from 2 years ago would have been deducted on the income statement from 2 years ago; the only portion that would affect this year’s income statement is the amortization (part of the $2,000 of this year’s amortization).
And so on.
Ahh, so moving from capitalizing to expensing, would restate the previous years income statement?
If you’re merely trying to adjust this year’s P/E ratio, there’s no need to adjust prior years’ income statements.
If you’re doing some sort of trend analysis, then you’d want to adjust prior year’s statements.
Yes of course, thanks a lot, feel a bit stupid I didn’t understand this…
You’re welcome.
No reason to feel stupid; there’s a lot of material here and it can become overwhelming.