How come ROA and ROE are increased after the first year when a firm expenses vs. capitalizing an asset?
I understand how net income would rise after the first year from expensing, but wouldn’t equity also rise as well due to the higher net income in the period?
Equity comprises preferred stock, common stock, additional paid-in capital, and cumulative earnings since forever. It’s expected to be much higher than net income for any one year.
If income increases 10%, equity may increase 0.1%, or 1.0%.
If you expense the cost, then your net income will be lower in the first year, thus bringing about a reduction in Net Income, which reduces the ROA and ROE.
If you capitalized, Net Income is high in year 0 when the asset is purchased, and ROE and ROA are higher, but in subsequent years when you depreciate the asset, Depreciation expense will be charged to your income statement, which reduces your Net Income, and thus you have a reduced ROE and ROA.
Hope that helps.
How does capitalizing an asset affect stockholders’ equity on the B/S then?
If you capitalize, your assets are higher, so your equity (specifically, retained earnings) will be higher.
true…