Capitalizing vs. Expensing

I thought I understand capital lease but keep getting different explanations from schweser questions. Which of the following statements about capitalizing and expensing the cost of a lon-lived asset least accurate? A. A company that capitalizes the cost will have lower debt-to-asset and debt-to-equity ratios than a company that expenses the cost B. A company that expenses the cost will show the same total cash flows as the capitalizing firm, but will show higher profitability early in the asset’s life. C. In the early years of the asset’s life, a company that expenses the cost will have lower profitability ratios, such as return on assets and return on equity, than a company that capitalizes the cost. The answer is B, can someone please explain? I thought in the early years on capital lease, ROE is lower.

Heres a summary dude i hope this helps CAPITAL LEASE Balance sheet: Record Asset and Liability. Current Assets are the same but Non Current Assets increase. So does Current Liability and Long Term Debt pending on the lease strructure. Income Statement: Record interest expense & Depreciationed, Total expenses earlier years is higher thus profits will be lower Statement of Cashflow: Chashflow is split between operating and finance, Thus CFO is higher because cashflow from operations is lower OPERATING LEASE Balance Sheet: NO ENTRY Thus assets and liabilities are lower relative to capital lease Income Statement: Record Rent Expense Statement of Cashflows: Entire lease payment is under CFO thus CFO will be lower relative to capital lease RATIOS ANLYSIS FOR CAPITAL VS OPERATING (Early Years) Net Profit Margin : Net Income/Sale thus under capital lease Net income will be lower so operating lease will show a higher Net Profit margin (In the earlier years) Return On Equity: Net Income/Equity, Net income goes down thus capital lease will be lower realtive to operating (In earlier Years) Asset Turnover: Sales/Assets, Assets up this ratio will be lower under a capital lease Interest Coverage: Ebit/Int expense, Interest expense up therefore Interest coverage will be lower for a capital lease.

Correct Answer should be A, because it’s the option that is least accurate. A company that capitalizes the cost will have a higher (as opposed to lower) debt-to-asset and debt-to-equity ratios than a company that expenses the cost.

When you expense it, you have high expense in the “beginning”, so you have lower NI than capitalizing. So if you capitalize, you have higher NI, therefore higher profitability in early years of asset’s life.

Chung - based on your explanation do you agree that answer C is least accurate and schweiser is wrong - you wrote “Return On Equity: Net Income/Equity, Net income goes down thus capital lease will be lower realtive to operating (In earlier Years)” which contradicts C and B is actually an accurate explanation.

Chung- Thanks, so how come B is not true? I think the answer is C. This is question 61 of the vol 1 exam 2 afternoon test. I checked errata, doesn’t see this.

I think both A and B are not accurate. A - least-er because both debt-asset will be higher. And Debt to Equity will be higher capitalized. (as Damil pointed out) B - Cash flow portion accurate. But profit margins not accurate. So A qualifies as least accurate I guess. comment

C is wrong A firm that expenses the cost is under an operating lease. Thus in the earlier years your profit margin and return on assets/equity will be higher. for operating lease. Answer B is wrong becaseu Cash flow from operations will be different under the two metheds One will be overstated and one will be understated. The thing is C is also wrong. The key to understanding operating vs cpaital is that in the earlier years capitla lease expenses are greater than operating expenses Interest expense + Depreciation expense > rent expense. Is there a typO here?

Damm - this is not a capital lease ? it is just a capitilizing ? I see now

Now that I think about it, answer is indeed B. Option A Expensing the cost will have no effect on the liability (debt) side of the balance sheet but will decrease asset (reduction of cash) and equity. And so Debt-to-asset and debt-to-equity will both increase. Decreased denominator. For capilized firm, it’ll be the opposite effect. So this statement is accurate. ------------------------ Option B Expensing the cost will show a higher profitability early in the asset’s life is wrong, because expensing the cost will have a higher impact on net income as opposed to capitalizing it. So this statement is the least accurate, although the first part of the statement is accurate in that both firms will have the same TOTAL cash flows over the life of the asset. --------------------------- Option C Expensing the cost will have a lower profitability ratio because of reduced net income…etc. So this option is accurate.

I saw another post that confused “capitalizing” w/ “capital lease” they are not the same thing. there are TWO different animals here - 1. Capitalizing vs. Expensing - “capitalizing” means you spread out the expense over a period of time (smoothing out), expensing means you recognize the entire expense in the current period. Check out R&D and software development examples for these topics. 2. Operating Leases vs. Finance (capital) leases - are two different treatments for leases that *only* apply to leases and nothing else. Chung’s post is accurate and good at explaining lease treatments, but its not what the question is asking. the answer is B because a company that expenses costs will show LOWER profitability in the early part of the asset’s life due to HIGHER expense being reported.

Thanks for the great summary chung.

slorte Wrote: ------------------------------------------------------- > I saw another post that confused “capitalizing” w/ > “capital lease” > > they are not the same thing. > > there are TWO different animals here - > > 1. Capitalizing vs. Expensing - “capitalizing” > means you spread out the expense over a period of > time (smoothing out), expensing means you > recognize the entire expense in the current > period. Check out R&D and software development > examples for these topics. > > 2. Operating Leases vs. Finance (capital) leases - > are two different treatments for leases that > *only* apply to leases and nothing else. > > Chung’s post is accurate and good at explaining > lease treatments, but its not what the question is > asking. > > > > > the answer is B because a company that expenses > costs will show LOWER profitability in the early > part of the asset’s life due to HIGHER expense > being reported. +1. I agree. This question is about capitalizing versus expensing. That makes B the correct answer.

Yeah i thought he was referring to capital lease indeed. B is def correct.

Holy shit. So much contradiction in this thread…

Got it, I misunderstood the question.