Capitalization vs. Expensing – Capitalization is recording a cost like an asset, despite an expense. Such consideration is done while a cost is not believed to be disbursed entirely over the existing period; instead, in a prolonged period. Therefore, removing an essential item from the company’s income statement while consecutively including it on the firm’s balance sheet for just showing the depreciation as a key charge contrary to profits may significantly lead to the expanding profits.
Considering the telecom giant, WorldCom, whose major portion of expenses comprised 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 was 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 1990s. Therefore, these expenditures were removed from the company’s income statement, thereby increasing the profits by several billion dollars. Across Wall Street, it looked like WorldCom suddenly started delivering profits even in a downturn that the industry experts skipped 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 vital for the financial analyst –
Capitalization vs Expensing
Capitalization is the recording of an expense or an asset. It is done when it is believed that the benefits of such expenses will be derived for an extended period. For instance, office goods are believed to get spent fast. Thereby, they are treated to be spent simultaneously. On the other hand, a vehicle is recorded as an immovable asset and expected to be spent significantly over time via depreciation. The vehicle is expected to get consumed over a much longer period than the office supplies.
Expensing assumes any expenditure like an operating expense instead of 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.
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Capitalization Example
Suppose a company buys a car worth $50,000 in 2017. Since the company has paid for this expense, should we take this expense ($50,000) in the Income statement for 2017, or should we record this expense as something else? You got it!
Let us assume that a car has a useful life of 10 years. The company can benefit from this car until the 10th year. Therefore it will not be wise to record all the expenditures in the Income Statement. Instead, we should capitalize on this expense of $50,000 and reduce it by the 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 DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more.
Capitalization vs Expensing – Key Differences (Summary)
The major suggestion for choosing between expensing and capitalizing is to report profit every period. If one chooses to capitalize on any asset against expense, it leads to greater profits while successively leading to greater taxes and improved business value. However, selecting expenses for any asset rather than its capitalization would deliver just the opposite results.
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 still has economic value. It is believed to benefit prospective periods and thus is mentioned over a balance sheet. An expense comprises the core economic costs 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 include supplier payments, employees’ wages, factory leases, and equipment depreciation.
Also, check out – Capital Lease vs Operating LeaseCapital Lease Vs Operating LeaseThere are several methods for accounting for leases. In the event of a capital lease, at the end of the lease period, a lessor can transfer the ownership of the asset to the lessee; however, in the case of an operating lease, the ownership of the asset under consideration is retained by the lessor.read more
Capitalization vs Expensing Example
In 2016, the company discovered that $2,250 of its operating expenses should have been capitalized, which would also have increased depreciation expenses 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 capitalized 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 TaxesEarnings Before TaxesPretax income is a company’s net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense.read more.Additional Depreciation expense of $300 should be reduced.
Calculate Ratios – Capitalization vs Expensing
Adjusted Profit MarginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more = Adjusted Net Income / SalesAdjusted Profit Margin = $4,515 / $60,000 = 7.5%Adjusted Profit Margin increases due to increase in the Net Income
Adjusted Return on Capital = (Adjusted Net Income + Interest Expense) / Average AssetAdjusted Return on Capital = ($4,515 + $750) / (29,100 + 32,850)/2 = 17%In this formula, the numerator increases an increase in the adjusted net income; however, denominator increases due to an increase in the adjusted Asset of 2016.We note that the impact of the increase in the numerator is higher than that of the denominator, thereby increasing this ratio from 13% to 17%
Adjusted Cash flow from OperationsCash Flow From OperationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more = Cash flow from operations (before adjustment) + Operating expenses incorrectly deducted.Adjusted Cash flow from Operations = $3,300 + 2250 = $5,550
Adjusted Cash flow from InvestmentsCash Flow From InvestmentsCash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow.read more = Cash flow from investments (before adjustment) – Capitalized expenseAdjusted Cash flow from Operations = -$1,500 – 2250 = – $3,750
If we ignore the tax impact due to changes in the Net Income, the total cash flow remains the same at $150
Adjusted Long Term Debt to Equity = Long Term Debt / Adjusted Equity = $9,150/17,250 = 53%
We note that most of the ratios have shown a positive impact after capitalization.
Capitalization vs Expensing – Effect on Financial Statements
Capitalizing the costs would usually impact the firm’s financial statements. Some critical areas involved while performing asset capitalization coupled with the way they may alter the firm’s financial statements include,
Balance Sheet Effect – Capitalization vs Expensing
- The firm’s consolidated assets would grow upon capitalization of its costs.The impact on shareholders’ equity would be negligible over the longer term; however, in the beginning, stockholder’s equity would be greater.
Income Statement Effect – Capitalization vs Expensing
- 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.
Cash Flow Effect – Capitalization vs Expensing
- Suppose the firm capitalizes its expenditures. The influence would be just on cash flow from operations and cash flow from Investments
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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 into two key segments,
- Assets that deliver prospective gainsAssets 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 statementsFinancial StatementsFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more.
An easy instance may be the payment of an insurance policy. The firm may purchase a fixed-dated policy for two years while paying the entire cost in one go. As the insurance would also assist the firm, it may capitalize on 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, they still deliver benefits for the company. Some examples of intangible assets include copyrights, patents, or research and development expenditures.
Patents
- Internally developed patents don’t show up in the Balance SheetThe Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read moreSFAS 2 requires all costs incurred with the development of the patents be expensed as they are incurredPatents acquired in an arm’s length transaction will show up in the balance sheet at the cost paid to buy itPatents are amortized using the legal life or the useful life, whichever is shorter
Goodwill
- Goodwill can only be recorded when a firm buys another firmArm’s length transaction is evidence of the value of GoodwillUnder SFAS 142, Goodwill is no longer amortizedGoodwill Is No Longer AmortizedGoodwill amortization refers to the process in which the cost of the goodwill of the company is expensed over a specific period of the time i.e., there is a reduction in the value of the goodwill of the company by the way of recording of the periodic amortization charge in the books of accounts.read more but tested for impairmentWhen Goodwill is impairedGoodwill Is ImpairedGoodwill impairment is the process of writing off the accounting charge amounting to the excess of the acquired asset’s book value as recorded in the financial statements over its fair value. A higher impairment charge reflects the company’s irrational investment decisions. read more, it is written down & loss passed through the income statement in the current periodManagers may have incentives to write down a lot of goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company’s net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company’s net identifiable assets from the total purchase price.read more, or never write down goodwill at all
Advertisements
- 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 measureGAAP requires immediate expensing of most advertising costsMore conservative than capitalization!
Accounting for Research and Development
Future benefits from R&D expenditures is highly uncertain at the start of a projectSFAS 2 requires virtually all R&D expenditures to be expensed as incurredPrinciple of conservatism accountingPrinciple Of Conservatism AccountingThe conservatism principle of accounting guides the accounting, according to which there is any uncertainty. All the expenses and liabilities should be recognized. In contrast, all the revenues and gains should not be recorded, and such revenues and profits should be recognized only when there is reasonable certainty of its actual receipt.read more is applied in case of R&DHowever, 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 the purchase price be allocated to in-process R&D and be immediately written offManagers 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 developmentSoftware development cost is a major cost for many small, growth service companies, and that’s their main asset.It prompted FASB to be more liberal while formulating SFAS 86
Limitations of Capitalization and Expensing
Capitalization
- The thumb rule for any asset capitalization is that if that asset has a long-term gain or value growth for the firm, there seem to be some drawbacks to this law. For instance, the costs of research & development (R & R & R & R&D) costs are incapable of being capitalized, although such assets strictly offer long-term benefits to the company.One key reason 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 of analyzing R&D costs.In addition, an asset’s capitalization may exaggerate the values of assets, as depicted on the firm’s balance sheet, which can influence the company’s financial statements to some extent.Lastly, it is crucial to recollect that inventory costs can’t be capitalized. Even after one may be willing to hold that inventory over the long term and plans to sell it in the forthcoming business cycleBusiness CycleThe business cycle refers to the alternating phases of economic growth and decline.read more, expenses cannot be capitalized.
Expensing
- While beginning a business, there are some critical limitations regarding expenses. In several cases, instant costs may be capitalized despite not necessarily falling under the firm’s capitalization rules for the starting financial year.As R&D costs are usually taken as an expense, some legal fees related to the asset’s acquisition can be capitalized, coupled with the patent fees.Furthermore, one must remain cautious while expending costs related to upgrades or repairs. If an item’s value improves notably or the item’s lifespan increases, the costs may better be capitalized.Lastly, expense lowers the business’s total income earned, and hence, one must be cautious about ensuring that the near-term funds can adjust this modification.
Conclusion – Capitalization vs Expensing
Capitalization against spending is a vital aspect of any business’ financial policymaking. Costs may significantly impact the company’s business finances, while it is crucial to acquire the capability to harness benefits from both capitalization and expense.
The accounting management of expenditures can be a critical difference between any lucrative income statement and the one that illustrates a loss. As a result, it could be challenging to select from these options. However, at large, capitalization against expenses may offer the business significant growth opportunities while keeping the company’s future bright.
