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Capitalizing Versus Expensing

Capitalizing Versus Expensing

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Capitalizing Versus Expensing
Capitalizing Versus Expensing

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Published by: Fathi Salem Mohammed Abdullah on Oct 13, 2009
Copyright:Attribution Non-commercial


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Capitalizing versus Expensing:
by Fathi SalemExpenses can be expensed as they are incurred, or they can be capitalized. Acompany is able to capitalize the cost of acquiring a resource only if the resourceprovides the company with a tangible benefit for more than one operating cycle.In this regard, these expenses represent an asset for the company and arerecorded on the balance sheet.
Financial Statement and Ratio Effects
A company that capitalizes its costs will display higher profitability ratios at theonset and lower ratios in the later stages. Liquidity ratios will experience littleimpact, except for the CFO ratio, which will be higher under the capitalizationmethod. Operation-efficiency ratios such as total asset and fixed-asset turnoverwill be lower under the capitalization method, due to higher reported fixed assets.Furthermore, at the onset, equity turnover will be higher under the capitalizationmethod (lower total equity due to lower net profit). Companies that capitalizetheir costs will initially report higher net income, lower equity and higher totalassets. Remember that, on average, an equal dollar effect on a numerator anddenominator will produce a higher net result. That said, on average, ROE & ROAwill initially be higher for capitalizing firms. Solvency ratios are better for firmsthat capitalize their costs because they have higher assets, EBIT andstockholders' equity.Capitalization is an important part of accounting. It affects both financialstatements and their ratios. It also contributes to the superiority of earnings overcash flow as a measure of financial performance. This section examines theeffects of capitalization (and subsequent allocation) versus immediate expensingfor income measurement and ratio computation.
Effects of Capitalization on Income
Capitalizing costs and depreciating them over time will show a smoother patternof reported incomes. Expensing firms have higher variability in reported income.In terms of profitability, in the early years, a company that capitalizes costs willhave a higher profitability than it would have had if it expensed them. In lateryears, the company that expenses costs will have a higher profitability than itwould have had if it capitalized them.Capitalization has two effects on income. First, it postpones recognition of expense in the income statement. This means capitalization yields higher incomein the acquisition period but lower income in subsequent periods as comparedwith expensing of costs. Second, capitalization yields a smoother income series.Why does immediate expensing yield a volatile income series? The answer isvolatility arises because capital expenditures are often ‘lumpy’—occurring inspurts rather than continually—while revenues from these expenditures areearned steadily over time. In contrast, allocating asset cost over benefit periodsyields an accrual income number that is a more stable and meaningful measure of company performance.
Effects of Capitalization for Return on Investment 
Capitalization decreases volatility in income measures and, similarly, return oninvestment ratios. It affects both the numerator (income) and denominator(investment bases) of the return on investment ratios. In contrast, expensingasset costs yields a lower investment base and increases income volatility. Thisincreased volatility in the numerator (income) is magnified by the smallerdenominator (investment base), leading to more volatile and less useful returnratios. Expensing also introduces bias in income measures, as income isunderstated in the acquisition year and overstated in subsequent years.
Effects of Capitalization on Solvency Ratios
Under immediate expensing of asset costs, solvency ratios, such as debt toequity, reflect more poorly on a company than warranted. This occurs becausethe immediate expensing of costs understates equity for companies withproductive assets.
Effects of Capitalization on Operating Cash Flows
A company that capitalizes its costs will display higher net profits in the first yearsand will have to pay higher taxes than it would've had to pay if it expensed all of its costs. That said, over a long period of time, the tax implications would be thesame. But the choice for capitalizing over expensing have a much larger effect onthe reported cash flow from operations and cash flow from investing. If a companyexpenses its cost it will be included in cash flow from operations. If it capitalizes,then it will be included in cash flow from investing (lower investment cash flowand higher cash flow from operations).When asset costs are immediately expensed, they are reported as operating cashoutflows. In contrast, when asset costs are capitalized, they are reported asinvesting cash outflows. This means that immediate expensing of asset costs bothoverstates operating cash outflows and understates investing cash outflows in theacquisition year in comparison to capitalization of costs.
The figure bellow shows the effect of capitalizing versus expensing on key financial ratios:

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