I was doing a mock today and i got wrong a question which asked what caused EBIT to increase the most.
Capitalized Interest of 30M
Software Development cost of 4.5M
Deferred Revenue of some amount.
They answer was Capitalized interest, but i thought capitalized interest will dercrease EBIT because of the Depreciation Expense not increase it. Also since interest is below EBIT it should not affect it. If you remove the Capitalized interest effect on Depreciation it should increase EBIT.
When you expense “Software Development cost of 4.5M” it shows up on income staement as operating expense before EBIT, thats is why EBIT will be low in the first year.
When you capitalize “Software Development cost of 4.5M” it does not sows up on income statement as an expense so EBIT is higher in first year, it shows up on balance sheet as an asset. It depreciates over time thats why the the EBIT is low in future years in this case.
I understand the effects of the software cost.But the answer they said that caused EBIT to increase was because they capitalized the Interest. If you capitalize interest it should reduce EBIT because of the depreciation , so why they say that the capitalization caused EBIT to increase.
when you capitalise there are interest and depreciation (amortised ) exp reported in I/S the interest part will reported as operating cost ( above EBIT) and the depreciation is below EBIT , whereas when you expense, the total expensed item is reported as operating cost (above EBIT) , which makes EBIT lesser when compared to expensed . Schweser has shown the comparison in a table - with calculations . I suggest you to have a look at the cash flows
Well U have to see it in this way, when u capitalize anything, it gets to the B/S and not the I/S. As such the balance sheet gets bigger at the expense of the I/S
If u capitalize an expense, say interest, the assets in the B/S increase and the expense in the I/S reduce. Any reduction in expense is seen to increase operating profits(EBIT).