“Because the costs of capitalized assets are carried as assets on a firm’s balance sheet, capitalizing firms report higher assets and equity balances, which would decrease the debt-to-equity ratio.” This is the answer explained on a CFA practice test. I knew that the asset went on the balance sheet, but why does the equity change? And, what would the general label of the increase in equity be? Thanks.
A = L + E A = increases L = unchanged E = ? --> increase
That’s what I figured. But, does the equity go up because of anything on the income statement? Or is it just because the assets go up? In other words, does anything differ on the income statement between a cap. asset or leased asset?
Not right away…but eventually the capitalized asset will generate income that will flow through the NI to Equity.
Because of depreciation expense, higher NI will be reported, which will affect Equity, right?
Not right away, since depreciation will lower NI, but over the long-run. Is this right?
Delhirocks In a capitalized lease you have an asset which increased because of the PV (MLP) The same is also present on the Liabilities side. So L=Unchanged - I believe would be a wrong statement to make. I believe equity increases with respect to an Operational lease because: 1. Depreciation Expense + Interest expense in a capitalized lease is lower than Rent / Lease expense on an Operational lease. 2. So Higher Net Income is generated. 3. Which makes its way into equity as Retained Earnings. Does that make sense? CP
Throwing some logic Operating lease doesn’t show up on the balance sheet (footnotes) --> no effect on either debt or equity Capitalized lease: long-term asset, short-term liability + long-term liability --> higher debt (vs oper. lease) lower net income --> lower equity altogether debt/equity ratio of cap. lease is HIGHER make sense?
Upd lower net income is generated in the early years
Bigfin - This is a good question and I found a very tough concept to get my head around. The short answer is that yes, equity goes up when you capitalize. When you capitalize an asset as opposed to leasing it, you are deciding to spread the cost of that asset out over several periods rather than expensing or spending all the cost right now. This means that in the current period, your expenses will be lower when you capitalize, and thus net income and therefore retained earnings (equity) will both be higher. I don’t think this question has anything to do with the debt/ liability side, but rather the main point is that capitalizing a cost will increase both assets and liabilities. I also found that if you don’t have all the ratios from FSA memorized, it makes these concepts much harder to grab. I suggest flash cards for all the ratios until you get em down, then when you hit these concepts they will come much faster and save you time. Good luck with the next two weeks -
Thanks people. Believe it or not, I am learning a ton from this website. Good luck to eveyone, too.
bigfin, if you’re talking about question 40 of test 4, then you posted the wrong question description… it asked compared to expensing the COST of long lived asset, what would capitalizing do, this has nothing to do with leasing
does anyone know what the actual accounting entries are when capitalising an expense? DR ?? CR ??
Initially: Add the Present value of the lease to debt and assets. Ongoing: depreciate the asset on the balance sheet, amortise out the “debt”, deduct interest expense on Income statement. CFO: Interest expense goes in here, Principal payments go in CFF.
ok but what if it wasnt a lease expense? what if we’re capitalising interst for example? im just trying to work out the original post… the fact that “capitalizing firms report higher assets and equity balances” because, initially, it wouldnt… it would increase assets and liabilities by the same amount, but not affect equity…
For there to be interest, there has to be a debt - be it a lease or an actual debt. For it to be capitalised there has to be an asset. You can’t just “capitalise interest” in a vacuum. >because, initially, it wouldnt… it would increase assets and liabilities by the same amount, but not affect equity… Sure, so at T=0, you have the same amount of equity. But at T>0, you have lower expenses than if you expensed the cost all in year 1, so you have higher net income, which translates into higher equity.
Hey Huys, I think the comparison between capitalizing versus expensing costs and capital leases versus Operating lesaes are mixed up in our discussion…
Bohmbach Wrote: ------------------------------------------------------- > Bigfin - This is a good question and I found a > very tough > concept to get my head around. The short answer > is that > yes, equity goes up when you capitalize. > > When you capitalize an asset as opposed to leasing > it, you > are deciding to spread the cost of that asset out > over several > periods rather than expensing or spending all the > cost right > now. This means that in the current period, your > expenses > will be lower when you capitalize, and thus net > income and > therefore retained earnings (equity) will both be > higher. > > I don’t think this question has anything to do > with the debt/ > liability side, but rather the main point is that > capitalizing a > cost will increase both assets and liabilities. I > also found that > if you don’t have all the ratios from FSA > memorized, it makes > these concepts much harder to grab. I suggest > flash cards for > all the ratios until you get em down, then when > you hit these > concepts they will come much faster and save you > time. > > Good luck with the next two weeks - This is incorrect and you’re misleading people here. When you capitalize an expense - yes equity is higher in the year of capitalization, because (as you put it) you are spreading the cost over a number of years vs taking it all in the first year. However, when you capitalize a lease, Equity is lower in the early years (vs capitalizing). Why? Because – when recording as a capital lease, interest expense & depreciation exceeds the annual lease payment – in the early years (which is the only reported expense when recording an operating lease). The result is lower net income, lower retained earning and lower equity. These effects will reverse over time. At the end of the lease period, the total expense will have been the same – in the later years depreciation expense & interest expense is less than the annual lease payment.
Thanks robert0s. I’m talking poo today. I always get mixed up between whether int exp + depr > lease payment. Of course the interest expense decreases over the life of the asset (as the bv is being depreciated), so the net income is lower in earlier years. >However, when you capitalize a lease, Equity is lower in the early years (vs capitalizing). should be (vs expensing) though to add to the confusion!
Yes you’re right. Sorry about the typo. Guess I should slow down on my typing