Hi everyone, I am studying the capitalization decision chapter and I have a few questions. I would really appreciate if somebody could answer them: 1. When we capitalize an expense, it becomes an asset. But, to keep the equality A=L+SE, what changes on the right hand side while assets increase? 2. The book says that companies that capitalize expenses will show lower cash flow from investing. Why is that? Thank you!
Answers as follows (i think): 1) Asset is recorded, you increase a liability (wages payable (if self perform), contracts payable, lease payable) 2) If said asset is leased, a portion of the lease payment, the interest expense portion, is viewed as CFO, the principal portion is viewed as CFI as you are paying on equipment, land, etc. that you have purchased. At least that’s the way I think it is.
For the first point on capitalization, you can also balance the equation by a reuction in another asset, ie cash. So as an example, you pay cash for a roof repair on a building. If you expense it you have the debit to expense (which reduces net income and SE), and a credit or reduction to cash. If you chose to capitalize that expenditure the debit is to building improvement. This expenditure, if capitalized, is also a use of funds in the investing section, reducing CFI.
Thank you for your answers…