Two questions

When going through the capitalization vs expensing section of the financial statement analysis book I noticed that it says that assets and equity are lower in businesses that expense rather than capitalize. Why is this? If you expense an asset purchase does it not showup on the balance sheet as an asset? Also, in the inventory section of the financial statement analysis book, it says that using LIFO during periods of rising costs results in higher cash flow and lower net income. The lower net income part is easy to understand, but I can not figure out why it results in a higher cash flow. It makes sense to me, but when I try to reconcile a cash flow statement from the income statement (using indirect method) I can not figure out how LIFO will result in a higher operating cash flow. The first number I start with will be net income, and then I will adjust back noncash expenses. Net income will immediatly be lower under LIFO. If someone could help clear these two issues up for me I’d appreciate it. Thanks

If you expense the assets, they wont show up in Balance sheet. You will show expense (equal to cost of asset) in your income statement. If you capitalize asset, it will be shown on balance sheet (asset and equity) and be depreciated over useful life of asset. This will reduce the expense on income statement as cost will be expensed over several years. Under LIFO COGS is high, so Income before tax will be low. This will result in lower tax payable. Taxes are operating cash outflow. Lower tax means lower cash outflow so higher CFO.

Ah, that is what i suspeced in regards to the expensing assets. thanks. As for the LIFO…aren’t taxes reflected in net income already and net income is carried over to the cash flow statement? I’ve never seen taxes listed as a cash outflow in CFO…I thought the tax impact was accounted for in net income and any taxes payable or accrued changes (noncash) were added to net income when reconciling net income to CFO.

Look at calculations for Direct method… they explicitly deduct taxes paid.

sumit_kansal Wrote: ------------------------------------------------------- > Look at calculations for Direct method… they > explicitly deduct taxes paid. But what about indirect method? How does the tax savings carry over to CFO when using the indirect method?

if there are tax savings, you would pay lesser taxes in a future year, and that would mean a higher Net income you start out with on your indirect statement. Or am I thinking completely wrong?

It seems to me that LIFO would always result in lower CFO if you’re using the direct method to calculate CFO. Net income in LIFO is always much less and therefor you start off the indirect cashflow statement with net income before reconciling. All of the noncash and working capital changes will be the same regardless of whether you use LIFO or FIFO.

I found the answer. The cash flow statement difference in taxes is picked up in the change in the inventory account when you reconcile with the indirect method.

Simplest way in my opinion is to remember the depreciation is simply the allocation of cost. You either let it hit right away (expense) or spread the damage out (capitalize). Expensing recognizes the cost when incurred while capitalization will spread the cost of that asset over the useful life.