I think there are two correct answers to this question and I think it’s BS…From CFAI exam 3: Two companies are identical except for their accounting treatment for R&D costs. One company expenses all R&D immediately while the other capitalizes a portion of the costs. Compared to the company that capitalizes costs, the expensing company will most likely: A) earn a lower return on assets B) have lower financial leverage C) exhibit a smoother pattern of net income over time D) report lower cash flow from operations correct answer was D only. but, expensing company will report lower return on assets now, higher return on assets in the future. is that why it’s not A? because in the future, the return on assets will be higher?
i would have picked A dont think it has to do with the cash flow
it does have to do with the cash flow, the capitalized portion is classified as investing. but, i think a can also be correct
ignore my post
What about a ROA larger than 100% ?
slave, you may be considering the financial statement effects of capital- vs. operating leases, rather than capitalizing vs. expensing of R&D. It’s often difficult to determine with any certainty and/or precision whether current R&D costs will result in increased future assets, sales and earnings. This is part of the reason R&D is expensed, but permitted to be capitalized for software after economic feasibility is demonstrated. Anyway, all we can say with any certainty in this problem is that the expensing firm will have lower total assets than the capitalizing firm, so holding all-else constant (particularly earnings), ROA will be higher for the expensing firm.
I think I found the answer - page 161 of schweser book 3. “Consistent with the effects of expensing versus capitalizing, capitalizing development costs will increase current net income. If expenditures are increasing, future net incomes will be greater for the capitalizing firm. Thus, return on assets will be greater and debt to equity lower for the capitalizing firm. If development expenditures are decreasing, then the amortization of the capitalized expenditures will result in lower future net incomes (and lower ROA) for the capitalizing firm.” Last sentence is crucial. Thanks for the input guys.
I got caught too!! I answered A… I hope tricky wording like this isn’t too pronounced in the actual exam. I guess the thing is “most likely”. Like Hannoversch said, what if NI / TA is higher tan 100%? Which means it’s possible to get higher ROA. Where as you should always have lower CFO when expensing as opposed to capitalising.