capiltalize R&D expense

if capitalize it, why ROA/ROE will be higher in early years, and lower in later year than expensing method? Thanks. if capitalize it, asset increase, but nothing happen to liabilty. what happen to net income? higher in early year and lower in later year compare with expense method? but why? Thanks.

Let’s imagine that instead of deducting $1000 in R&D expense in a single year, it gets capitalized over 10 years. That means that this year’s depreciation charge is $100. That’s $900 less than the cash expense charged against net income under expensing. So net income is higher by $900 (ignoring taxes). Assets are also higher by $900, because the balance sheet gets $1000 assets and $100 in depreciation. As discussed in other threads, an increase of the numerator and denominator by the same amount makes the fraction approach 1. Since ROA and ROE are typically less than one, that means they increase as a result of the capitalization. Note that the $900 in increased net income would also flow through to retained earnings. The retained earnings increase would balance the assets increase and the effect on ROE would be identical to the effect on ROA.

thanks very much. for R&D, I assume expense are constant, going on . so, for capitalize the expense will make ROE/ ROA lower in later years? Thanks. chebychev Wrote: ------------------------------------------------------- > Let’s imagine that instead of deducting $1000 in > R&D expense in a single year, it gets capitalized > over 10 years. That means that this year’s > depreciation charge is $100. That’s $900 less > than the cash expense charged against net income > under expensing. So net income is higher by $900 > (ignoring taxes). Assets are also higher by $900, > because the balance sheet gets $1000 assets and > $100 in depreciation. As discussed in other > threads, an increase of the numerator and > denominator by the same amount makes the fraction > approach 1. Since ROA and ROE are typically less > than one, that means they increase as a result of > the capitalization. > > Note that the $900 in increased net income would > also flow through to retained earnings. The > retained earnings increase would balance the > assets increase and the effect on ROE would be > identical to the effect on ROA.

Chebychev - so extending the same logic, would you say that this is the only reason why capitalising a LEASE causes the Debt/Asset ratio to increase; simply because we are adding a constant to the denominator and numerator. I’m asking this because I want to see whether there are other things going on that cause the Debt/Asset ratio to go up in this instance

Yes, ROE and ROA would be lower in later years under capitalization. That’s because with expensing, you’ve taken all the expense in year one. There’s nothing to deduct against net income in subsequent years. Under capitalization, you still have those depreciation charges coming in year after year. Thus, after year one, net income is slightly lower under capitalization than it would have been under expensing. This in conjunction with the higher assets and equity under capitalization would result in lower ROE and ROA in later years.

HakunaMatata, my analysis was for capitalization of R&D expenses. Capitalization of a lease is a different ball of wax because a liability is added to the balance sheet.

yep, acknowledged (that’s why i put it in capitals); sorry for changing the subject We know that an asset and a liab are added to the bal sheet when capitalising the lease, so adding some extra debt to the numerator and extra assets to the denominator of the fraction are the only reasons why Debt/Asset ratio goes up? Or are there second round effects that cause this?

I think you’ve described why debt to assets would increase when capitalizing a lease. I’m not sure any second order effects need to be considered with respect to the debt to assets ratio in the first year.