# Practice Exam Explanation Question...

“If a company chooses to capitalize an expenditure rather than expense it, the residual income model overestimates the value of a company. Accounting for changes in the value of investments considered “available-for-sale” biases the valuation by incorrectly stating ROE but not the book value of equity.” Why is this true? I thought you are supposed to maintain the clean-surplus relation by capitalizing and accounting for comprehensive income by adjusting for available-for-sale securities. Why does doing so incorrectly state ROE? What does incorrectly stating ROE have to do with RI valuation?

I think what it is trying to say is the following: There are two separate things going on here: 1. With respect to capitalizing an expenditure. When you capitalize an expenditure - Assets are increased (wrongly) and then depreciated thro’ the income statement. In the real world, if it had been left an expense - it would have reduced the current period Income statement and NI would have been lower. This action has overstated the value of the company. 2. With respect to the AFS security. In a Trading security - the NI figure would be adjusted which is the numerator in the ROE equation, and then NI flows into Equity. In an AFS security - NI figure is left untouched, but the unrealized gains/ losses flow into the Equity. NI/CE which is ROE is thus not a proper “figure”. Part 3: RIt = NIt - rBt-1 = (ROE-r)Bt-1 since ROE is not a proper figure - RI is also incorrect.

I thought we want to capitalize assets for the residual model?

capitalize assets - but here we are talking capitalizing expenses… is that the same thing?

i thought that Net Income was reduced in the early years once you capitalized an lease…but increases later on in the life of the asset. This would make RI underestimated under residual income…

ury – they are talking of an expenditure - not a lease.

expenditure as R&D? what else it could be, CP Your explanation is definitely helpful, never notice that area

Sorry, I mean capitalize expenses… Nevermind, that’s for calculating NOPAT and invested capital in calculating economic value added.

TheAliman - is my explanation as written correct then?

I was having problems with this also - My rationale was this: Capitalise stuff which you should not means that A increases, and therefore E increases. NI also increases because there is no depreciation. When E increases, the equity charge increases also…So you can’t tell what will happen…am not sure what is wrong with my way of thinking. if you cap. assets - depr will incr. so ni will go down, but by a lesser amount than if the entire expense had been taken. So you are overstating assets and equity, understating the NI. So ROE figure will be a wrong #.

H Rainbow - don’t you have depreciation when you capitalize? You bring in on as an asset then depreciate over the life of the asset? This would lead to higher NI the first year, but lower the following years b/c of depreciation.

So when you have operating leases, what do you do in order that the clean-surplus relation holds (to be able to use an RI model)? If you can’t capitalize because NI is too high, and you can’t leave it as an operating lease because NI is too low, are you S.O.L?

cpk123 Wrote: ------------------------------------------------------- > I think what it is trying to say is the > following: > > There are two separate things going on here: > 1. With respect to capitalizing an expenditure. > When you capitalize an expenditure - Assets are > increased (wrongly) and then depreciated thro’ the > income statement. In the real world, if it had > been left an expense - it would have reduced the > current period Income statement and NI would have > been lower. This action has overstated the value > of the company. > > 2. With respect to the AFS security. > In a Trading security - the NI figure would be > adjusted which is the numerator in the ROE > equation, and then NI flows into Equity. > > In an AFS security - NI figure is left untouched, > but the unrealized gains/ losses flow into the > Equity. NI/CE which is ROE is thus not a proper > “figure”. > > Part 3: RIt = NIt - rBt-1 = (ROE-r)Bt-1 > > since ROE is not a proper figure - RI is also > incorrect. Yes, correct