Capitalization vs Expensing – Capitalization is defined as the recording of a cost like an asset, in spite of an expense. Such consideration is done while a cost not believed to be completely disbursed over the existing period instead, in a prolonged time period. Removing a key item from the company’s income statement while consecutively including it on firm’s balance sheet for just showing the depreciation as key charge contrary to profits, may lead to the expanding profits significantly.
Considering the telecom giant, WorldCom whose major portion of expenses comprised of operating expenditures referred to as the line costs. Such costs were remuneration offered to indigenous phone companies for using their phone lines. In general, line expenditures were treated normally like usual operating expenditures, however, it was assumed that a part of these expenses were real investments in undiscovered markets and are not expected to pay off for several years to come. This logic was employed by the company’s CFO, Scott Sullivan who started “capitalizing” his firm’s line costs during the latter part of 1990’s. Therefore, these expenditures were removed from the company’s income statement, thereby increasing the profits by a several billion dollars. Across Wall Street, it looked like WorldCom suddenly started delivering profits even in a downturn that was skipped by the industry experts until a major collapse that was witnessed later.
Worldcom declared bankruptcy in July 2002.
In this article, we discuss Capitalization vs Expensing and why it is very important for financial analyst –
- Capitalization vs Expensing?
- Capitalization Example
- Capitalization vs Expensing – Key Differences (Summary)
- Capitalization vs Expensing Example
- Capitalization vs Expensing – Effect on Financial Statements
- Rationale for Expensing or Capitalization
- Capitalization of Intangibles
- Limitations of Capitalization and Expensing
Capitalization vs Expensing?
Capitalization is the recording of an expense an asset. This is done when it is believed that the benefits of such expense will be derived for an extended period of time. For instance, office goods are believed to get spent fast, thereby they are treated to be spent simultaneously. A vehicle is recorded like an immovable asset and expected to get spent over significantly long time period via depreciation as the vehicle is expected get consumed over much longer time period compared to the office supplies.
Expensing is referred to as the assumption of any expenditure like an operating expense instead of as a capital investment. Considering taxation, an expense is reduced from income directly. Whereas an asset is depreciated or any business undertakes a series of reductions over the asset’s useful life.
If a company buys a car worth $50,000 in 2017. Now since the company has paid for this expense, should we take this expense ($50,000) in the Income statement of 2017 or should we record this expense as something else? You got it!
Let us assume that car has a useful life of 10 years. This means that the company can derive the benefit of this car until the 10th year. Therefore it will not be wise to record all the expenditure at once in the Income Statement. We should capitalize this expense of $50,000 and reduce it by the amount of value derived each year.
The value derived each year = $50,000/10 = $5,000
Therefore, we record the expense of $50,000 in the Asset at the beginning of 2017. During the year, we use $5000 worth of value, therefore the end of year Asset = $50,000 – $5000 = $45,000.
The above-discussed expense all through accounting is referred to as Depreciation.
Capitalization vs Expensing – Key Differences (Summary)
The major suggestion on a choice between expensing and capitalizing is while reporting profit every period. If one chooses to capitalize any asset as against expensing it leads to greater profits while successively leading to greater taxes as well as improved business value. However, if we select expensing for any asset rather than its capitalization would deliver just opposite results.
|Cost recorded as asset on the balance sheet||Cost recorded as operating expenditure on the income statement|
|While capitalizing any cost and later amortizing it results in the cost distributed over a longer time period||Under normal conditions, complete expense is incurred while making any purchase|
|For asset capitalization, it should possess valuable life that covers more than the existing year. These assets must be capable of running the entire business. However, any inventory being sold to customers doesn’t qualify to become capital asset. Fixed assets are generally considered like equipment, or a range of intangible assets like patents or copyrights. Usually, fixed assets ought to be depreciated as against being amortized.||While starting or purchasing a business, IRS enables one to remunerate the business beginning or procurement costs. The expenditures made to consume a patent, copyright, trademark or comparable rational property may be amortized. One may repay goodwill that is generally expected to be realized during sales owing to the ongoing usage of the reputation or name of any product or business that you intends to acquire. Generally, IRS allows one to repay geological expenditures that are intended to develop or locate petroleum wells all across the United States. One could even repay their research expenditures.|
|A General Rule: Any procurement beyond a specified dollar range is counted to be capital expenditure or capitalization||A General Rule: Purchasing lesser than the allocated dollar range is treated as an operating expenditure|
|As per accounting, upon an asset’s capitalization, it is assumed that the asset is still having economic value and it is believed to benefit prospective periods and thus is mentioned over a balance sheet.||An expense comprises of the core economic costs that are incurred by any business through daily operations for earning revenue. Every business is permitted to write-off all the tax-deductible expenditures on their specific returns for income taxes to minimize the taxable income, hence the tax liability. Most common business expenditures comprise of supplier payments, wages to employees, factory lease and depreciation of equipment.|
Also, checkout – Capital Lease vs Operating Lease
Capitalization vs Expensing Example
During 2016, the company discovered that $2,250 of its operating expenses should have been capitalized, which would also have increased depreciation expense by $300
Calculate Adjusted Total Assets & Equity
For calculating the Adjusted Total assets, we need to make the following changes –
- Since the expense is capitalized, we should add it to the Total Assets ($2,250)
- Incremental depreciation due to this capitlalized expense should be deducted from the total asset base ($300)
- Total Adjusted Equity = $15,300 + 2250 – 300 = $17,250
Calculate the Adjusted Income
Here again, there are two adjustments
- Operating Expense of $2250 should be added back to the Earnings Before Taxes
- Additional Depreciation expense of $300 should be reduced.
- Adjusted Profit Margin = Adjusted Net Income / Sales
- Adjusted Profit Margin = $4,515 / $60,000 = 7.5%
- Adjusted Profit Margin increases due to increase in the Net Income
Return on Capital
- Adjusted Return on Capital = (Adjusted Net Income + Interest Expense) / Average Asset
- Adjusted Return on Capital = ($4,515 + $750) / (29,100 + 32,850)/2 = 17%
- In this formula, the numerator increases increase in the adjusted net income, however, denominator increase due to increase in the adjusted Asset of 2016.
- We note that impact of increase in numerator is higher than that of the denominator, thereby increasing this ratio from 13% to 17%
Cash Flow from Operations
- Adjusted Cash flow from Operations = Cash flow from operations (before adjustment) + Operating expenses incorrectly deducted
- Adjusted Cash flow from Operations = $3,300 + 2250 = $5,550
Cash Flow from Investing
- Adjusted Cash flow from Investments = Cash flow from investments (before adjustment) – Capitalized expense
- Adjusted Cash flow from Operations = -$1,500 – 2250 = – $3,750
Total Cash Flows
- If we ignore the tax impact due to changes in the Net Income, the total cash flow remains the same at $150
Long Term Debt / Equity
- Adjusted Long Term Debt to Equity = Long Term Debt / Adjusted Equity = $9,150/17,250 = 53%
Summary of the Adjustment after Capitalization of Expense
We note that most of the ratios have shown positive impact after capitalization
Capitalization vs Expensing – Effect on Financial Statements
The choice about capitalizing the costs would usually impact the firm’s financial statements. Some key areas involved while performing asset capitalization coupled with the way they may alter the firm’s financial statements include,
Balance Sheet Effect
- Firm’s consolidated assets would grow upon capitalization of its costs.
- The impact on Shareholder’s equity would be negligible over the longer term, however, in the beginning, stockholder’s equity would be greater.
|Asset and Liability||Lower||Higher|
|Leverage Ratios (debt/equity, debt/asset)||Higher||Lower due to higher base|
Income Statement Effect
- The capitalization of costs would normalize the inconsistency of the firm’s reported income, since the cost would get shared between statements.
- From the profitability point of view, the company should enjoy greater profitability in the beginning.
|Income Variability||Greater variability||Smoothening effect on net income from year to year|
|Matching of revenues||Less matching of revenues and costs||Cost deferred and matched with revenues|
|Profitability (Early years)||Lower as all expenses flow through the IS||Higher as cost is amortized|
|Profitability (Later years)||Higher as all cost has been expensed||Lower due to amortization of capitalized cost|
Cash Flow Effect
- Suppose the firm capitalizes its expenditures, the influence would be just on cash flow from Operations and cash flow from Investments
|Cash Flow from Operations||Lower||Higher|
|Cash Flow from Investing||Higher||Lower|
|Total Cash Flows||Same||Same|
Rationale for Expensing or Capitalization
While determining whether any cost must be either expensed or capitalized, firms often employ an easier technique of separating assets in two key segments,
- Assets that deliver prospective gains
- Assets that don’t deliver any prospective gains
Some of the firm’s costs would just deliver a one-time benefit for the firm and thus, comes under the second segment. These are usually expensed costs since the business is not believed to enjoy prospective gains through them.
Instead, assets that offer prospective gains may frequently stand capitalized and hence, the expenses would be distributed across financial statements.
An easy instance may be the payment of an insurance policy. The firm may purchase a fixed dated policy for say two years while paying the entire cost in one go. As the insurance would assist the firm in near future also, it may capitalize the expenditures.
Capitalization of Intangibles
Organizations may even come across intangible assets that are non-monetary properties and don’t have any physical matter however still deliver benefit for the company. Some examples of intangible assets include copyrights, patents or research and development expenditures.
- Internally developed patents don’t show up in the Balance Sheet
- SFAS 2 requires all costs incurred with the development of the patents be expensed as they are incurred
- Patents acquired in an arm’s length transaction will show up in the balance sheet at the cost paid to buy it
- Patents are amortized using the legal life or the useful life, whichever is shorter
- Goodwill can only be recorded when a firm buys another firm
- Arm’s length transaction is evidence of the value of Goodwill
- Under SFAS 142, Goodwill is no longer amortized, but tested for impairment
- When Goodwill is impaired, it is written down & loss passed through income statement in current period
- Managers may have incentives to write down a lot of goodwill, or never write down goodwill at all
- Advertising is expenditures to inform potential customers about the product or services of the firm.
- The benefits of successful advertising may extend for many periods into the future, however, any such benefits are very difficult to measure
- GAAP requires immediate expensing of most advertising costs
- More conservative than capitalization!
Accounting for Research and Development
- Future benefits from R&D expenditures is highly uncertain at the start of a project
- SFAS 2 requires virtually all R&D expenditures to be expensed as incurred
- Principle of conservatism is applied in case of R&D
- However, when one firm buys another firm, the total purchase price must be apportioned among the individual assets acquired
- SFAS 2 requires that a portion of purchase price be allocated to in-process R&D and be immediately written off
- Managers have a strong incentive to allocate a large portion of the purchase price to purchased in-process R&D
Accounting for Software Development Costs
- More liberal for accounting internal expenditures for software development
- Software development cost is a major costs for many small, growth service companies and that’s their main asset
- This prompted FASB to be more liberal while formulating SFAS 86
Limitations of Capitalization and Expensing
- As the thumb rule for any asset capitalization is if that asset having long-term gain or value growth for the firm, there seem some drawbacks to this law. For instance, the research & development (R&D) costs are incapable of being capitalized, although such assets strictly offer long-term benefits to the company.
- One key reason why most nations deny the capitalization of R&D expenditures is to overcome the doubt about the gains. Evaluating whether the prospective gains from an investment would be problematic and consequently, it is simpler to expense such costs.
- However, local accountants in different countries may use different ways for analyzing R&D costs.
- In addition, an asset’s capitalization may exaggerate the values of assets as depicted on the firm’s balance sheet that can influence the company’s financial statements to some extent.
- Lastly, it is important to recollect that inventory costs can’t be capitalized. Even after one may be willing to hold that inventory over the longer term and plans to sell it in the forthcoming business cycle, but expenses cannot be capitalized.
- While beginning a business, there are believed to be some key limitations regarding expensing. In several cases, instant costs may be capitalized despite they not essentially falling under the firm’s capitalization rules for the starting financial year.
- One must also consider that as R&D costs are usually taken as an expense, some legal fees related to the asset’s acquisition coupled with the patent fees can be capitalized.
- Furthermore, one must remain cautious while expensing costs related to upgrades or repairs. If an item’s value enhances notably or the item’s lifespan increases, the costs may better be capitalized.
- Lastly, expensing lowers the business’s total income earned and hence, one must be cautious about ensuring that the near-term funds are capable of adjusting this modification.
Capitalization against expensing is believed to be a key aspect about any business’ financial policymaking. Costs may have huge impact on the company’s business finances while it is crucial to acquire a capability to harness benefit from both capitalization and expensing.
The accounting management of expenditures can prove to be a key difference between any lucrative income statement and the one that illustrates a loss. It could be difficult to select from these options. However, at large, capitalization against expensing may offer the business with significant growth opportunities while keeping the company’s future bright.