Compared with firms that expense costs, firms that capitalize costs can be expected to report: A) lower asset levels and higher equity levels in the early years of the asset’s life. B) higher asset levels and higher equity levels in the early years of the asset’s life. C) higher asset levels and lower equity levels in the early years of the asset’s life. D) lower asset levels and lower equity levels in the early years of the asset’s life. The answer is B, but I thought that net income is lower for capitalized leases (total lease expense of interest plus depreciation is > operating lease expense). And if net income is lower won’t equity be lower? So why isn’t the answer C?
holy moly I must be tired i was thinking about capitalizing leases and yet after re-reading the question half a dozen times I see it asks about capitalizing expenses…sigh
It’s definitely B Capitalizing means you bring the cost on the BS as an asset value. Hence higher assets. This also means you’re not expensing the cost right away. So for a 250K purchase for example, you bring that on the BS and then depreciate it over a certain period using DDB or SL methods. If you took that cost and expensed it initially right upfront in year 1, your NI would take a severe hit. By smoothing out the expense over several years you’re NI looks a lot better and so do your profitability ratios. If your NI looks better so does your equity since Ret Earnings will be better. I’m actually encouraged that I knew that without having to look it up!!!