Capitalization vs. Expensing software development costs

CFA Level I FRA
#1

I am reading Example 7 | Solved problem | Page 480 | Curriculum Book 3 | Chapter : Long-lived Assets…

The example states that capitalized software development costs are reported as CFI, which makes sense. However, if we expense these cost, instead of capitalizing them, wouldn’t they flow through the income statement? In Question 1 b), they have simply subtracted the capitalized expense from CFO! I would believe that if these expenses are “expensed”, they would decrease the net income after considering the taxes, and in turn, reduce CFO. Isn’t it?

For instance, if CFO is 100, Capitalized expense is 5 (in CFI), and tax rate is 30%, EBITDA is 15, then new CFO won’t be 100-5 = 95 (which is what Curriculum has done) but CFO - ((EBITDA - Expense)*(1-tax)) = 100 - (15-5)*0.7 = 100-7 = 93. Correct?

I’d appreciate if someone could clarify this. I googled this topic, but I couldn’t find any good resource.

Thanks in advance.

#2

Your idea is correct, but your execution isn’t.

If the expense were capitalized it would reduce taxes by 5 × 30% = 1.5. Therefore, CFO would be:

100 – 5 + 1.5 = 96.5.

It appears that you’re subtracting the change in taxes when you should be adding it.

You should e-mail CFA Institute (info@cfainstitute.org) and mention this to them; it’s an error that they should correct.

#3

Thank you S2000magician. However, shouldn’t the net cash flow (i.e. total change in CFI and CFO) remain the same? I am unhappy with CFA because I wasted 4 hours on this. :frowning:

#4

Before-tax cash flow is the same.

After-tax cash flow might not be, as here.