Capitalizing vs Expensing

Which of the following statements about capitalizing and expensing costs is LEAST accurate? A)Companies that capitalize costs will have lower debt-to-asset and debt-to-equity ratios then expensing companies. B)Companies that expense costs will show the same total cash flows as the capitalizing firm but showhigher early year profitablity. C)Companies that capitalize costs and depreciate them over time will show smoother reported income then expensing. D)In the early years, companies that expense costs will have lower profitablity ratios, such as return on assets and return on equity, than capitalizing companies. your answer and WHY

A

because companies that cap costs, end up having higher debt-assets and debt to equity ratios D/A; higher debt, dperaciation lowers the assets over time D/e: higher debt, lower equity after first year

getterdone… dont confuse this with capitalizing a lease vs operating lease accounting… we are capitalizing an expense which doesn’t create a liability, just an asset that will be depreciated over time

Capitalizing costs makes long term assets go up, with no effect whatsoever on debt, the answer must be A.

map this is a LEAST ACCURATE question… A is a true statement

B-expensing will have lower early year profitability for taking the expense in a lump rather than depreciating over time, so NI will be lower in the first year.

B…companies that expense rather than capitalize will show the same cash flows, but will NOT show higher profitability in the early years. The lower net income will outweigh the lower assets in the ROA as well.

D- the sum of dep and interest in early years is more than the lease expense from operating lease.

I just woke up, no excuses though:)

For the past several weeks I have never felt awake, just in a CFA induced daze. you would think I would be better at the material because of this…

ahhhh didnt see the costs, thought we were talking about leases! just woke up as well!

mib20 Wrote: ------------------------------------------------------- > B…companies that expense rather than capitalize > will show the same cash flows, but will NOT show > higher profitability in the early years. The > lower net income will outweigh the lower assets in > the ROA as well. correct, and this was exactly the answer i was waiting for. So my question is this. I chose (B) based just on the false profitability part, but if that part wasn’t there i would have had a difficult time choosing (B) because cash flows have to be different due to the tax implication of now depreciating an asset… so when answering these questions when do we ignore the impact of taxes and when do we not??? the answer given was: Your answer: B was correct! The total cash flows are equal, but the expensing firm will see lower early year profitability rather than higher early year profitability.

Which is least accurate::: A)Companies that capitalize costs will have lower debt-to-asset and debt-to-equity ratios then expensing companies. Capitalize costs --> assets go up, so D/A goes down. TRUE. B)Companies that expense costs will show the same total cash flows as the capitalizing firm but showhigher early year profitablity. Same total Cash Flow–> TRUE Higher initial year profitability --> TRUE. Because some expenses have not been accounted for. My mistake --> I read this as company that CAPITALIZE costs. C)Companies that capitalize costs and depreciate them over time will show smoother reported income then expensing. TRUE… When you immediately expense in the period of expense --> your expenses are suddenly increased, so your income pattern is changed suddenly… so not smooth. D)In the early years, companies that expense costs will have lower profitablity ratios, such as return on assets and return on equity, than capitalizing companies. So this must be the least accurate. ROA will be higher --> because Assets the denominator is not as high. Equity is actually lower --> because NI component that feeds into the Equity is lower. So ROE would be higher. EDIT: This too was a Mistake. NI numerator has a bigger impact than the denominator. Answer changed to B (post fact, -1) CP

B - Expensing firms have to deal with the huge charge in the first year and profitability ratios will suffer. They will appear more profitable in successive years when capitalizing firms still have the depreciation expense.

total cash flows are the same under both methods

vbcfa Wrote: ------------------------------------------------------- > total cash flows are the same under both methods but that simply is not true… you pay less taxes after year one (a cash effect) when you capitalize vs expense. so the difference between CFO and CFI is not netted out to zero

in any case – that is the false statement, right, so what if both parts are wrong, or only 1 part is wrong. CP

CP that’s not my point. obviously (B) is the answer… I’m concerned with the answer rational given by Schweser… granted they are not impervious to mistakes but their answer clearly says that “cash flows are equal”

I think char-lee makes a good point, but for the test, i wouldnt think about it that way. But yes, if tax rates are changing over the course of the amortization of the capitalized expense, then cash flows will not net out to be equal uner the two methods.