Capitalize vs Expense cash flow effects

A firm that capitalizes rather than expensing costs will have: A) lower cash flows from investing. B) lower cash flows from operations. C) lower profitability in the earlier years.

Now my understanding is that when one capitalizes it mainly drives the net income higher which means one will end up paying more taxes on that year but since the accounting standard is not mentioned we presume they apply IFRS in which case the taxes paid can go under CFO or a portion of it can go under either CFI or CFF.Now my best guess was B but as it turns out it is wrong.Can anyone explain it??

I’d go with C

Overall CFs are the same regardless. CFI should be unaffected I think. Operating leases only touch CFO; Capital leases touch CFO and CFF (interest and principal pmts, respectively). So, capital leases reduce CF0 by less , resulting in higher CFO.

Profitability, for a capital lease, will be reduced by amortization of the lease and interest expense, which is larger than simply expensing the payments (operating lease). Not sure if that is clear, but there you go. Obviously, this difference in profitability balances out over the course of the lease as interest expense becomes smaller (as debt is paid off, annual interest shrinks).

Check it out, the answer is neither C nor B, it’s A - final answer. Babbabooey was right in the effects of capital and operating leases on the cash flow statement, but that’s not what the question is asking about. Leases aren’t a consideration here. The question is asking what effects the expensing/capitalizing of costs would have. As a rule of thumb, you expense costs that have uncertain, or no, impacts on future earnings, and you capitalize costs that result in higher future earnings as a result of continued usage.

_ Expensing: _

-Higher income variability

-Lower profitability in the first year (the year the expense is realized)

-Higher profitability in later years (as the full hit was taken in the first year)

-Total cash flows will be the SAME

-CFO would be lower (net income is lower as a result of the expense)

-CFI would be higher (expensing does not impact CFI)


-Income variability is lower (capitalizing smooths the cost’s impact on earnings over the useful life)

-Profitability is higher in earlier years (as no major expense was realized - it’s being smoothed out)

-Profitability will be lower in every year after the first (you have recurring costs associated with the asset, whereas you only had a single cost in the first year when expensing)

-CFO will be higher the first year (the impact of the full expense is not pulling net income down - the same smoothing effect)

-CFI will be lower

yes answer is A and i referred to the schweser videos and they have given the same notes. i just wanted to know the reasoning behind it and where did i go wrong in my reasoning.

Ahh, I misread the question-I was thinking capitalizing leases as opposed to expensing them each year as operating leases… cgottus is right.