Assets - Effects of Capitalizing Vs. Expensing

Expenses can be expensed as they are incurred, or they can be capitalized. A company is able to capitalize the cost of acquiring a resource only if the resource provides the company with a tangible benefit for more than one operating cycle. In this regard, these expenses represent an asset for the company and are recorded on the balance sheet.

Effects of Capitalization on Key Figures
The decision to capitalize or expense some items depends on management. As such, this choice will have an impact on a company's balance sheet, income statement and cash flow statement. It will also have an impact on a company's financial ratios.

Here is what the decision will have an impact on:

  • Net income - Capitalizing costs and depreciating them over time will show a smoother pattern of reported incomes. Expensing firms have higher variability in reported income. In terms of profitability, in the early years, a company that capitalizes costs will have a higher profitability than it would have had if it expensed them. In later years, the company that expenses costs will have a higher profitability than it would have had if it capitalized them.
  • Stockholders' equity - Over a long time frame, the choice of expensing a cost or capitalizing it will have little effect on a shareholders' total equity. That said, expensing firms will have a lower stockholders' equity at first (less profit, thus smaller retained earnings).
  • Cash flow from operations - A company that capitalizes its costs will display higher net profits in the first years and 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 the same. But the choice for capitalizing over expensing have a much larger effect on the reported cash flow from operations and cash flow from investing. If a company expenses 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 flow and higher cash flow from operations).
  • Assets reported on the balance sheet - A company that capitalizes its costs will display higher total assets.
  • Financial ratios - A company that capitalizes its costs will display higher profitability ratios at the onset and lower ratios in the later stages. Liquidity ratios will experience little impact, except for the CFO ratio, which will be higher under the capitalization method. Operation-efficiency ratios such as total asset and fixed-asset turnover will be lower under the capitalization method, due to higher reported fixed assets. Furthermore, at the onset, equity turnover will be higher under the capitalization method (lower total equity due to lower net profit). Companies that capitalize their costs will initially report higher net income, lower equity and higher total assets. Remember that, on average, an equal dollar effect on a numerator and denominator will produce a higher net result. That said, on average, ROE & ROA will initially be higher for capitalizing firms. Solvency ratios are better for firms that capitalize their costs because they have higher assets, EBIT and stockholders' equity.

Consider figure 8.2 below for an overview of the effect of capitalizing and expensing on key financial ratios.

Figure 8.2 Impact of Assets, Profitability on Financial Ratios

Computing the Effects of Capitalizing vs. Expensing
Related Articles
  1. Financial Advisors

    Tips on Passing the CFA Level I on Your First Attempt

    Obtain valuable tips and helpful study instructions that can help you pass the Level 1 Chartered Financial Analyst exam on your first attempt.
  2. Financial Advisors

    Putting Your CFA Level I on Your Resume

    Learn techniques for emphasizing your CFA Level I status in the Skills and Certifications or Professional Development section of your resume.
  3. Professionals

    Investment Analyst: Career Path and Qualifications

    Learn how to prepare for a career as an investment analyst, and read more about how many professionals in the field progress during their careers.
  4. Professionals

    CAIA Vs. CFA: How Are They Different?

    Find out how the CAIA and CFA designations differ, including which professionals should seek either title based on their career ambitions.
  5. Professionals

    Equity Investments: CFA Level II Tutorial

    Chapter 1: Equity Valuation: Its Applications and Processes Chapter 2: Return Concepts for Equity Valuation Chapter 3: Industry Analysis With Porter's 5 Forces
  6. Professionals

    What To Expect On The CFA Level III Exam

    The Chartered Financial Analyst Level III exam, which is only offered in June, is the last in the series of three tests that CFA candidates must pass.
  7. Professionals

    What To Expect On The CFA Level I Exam

    Becoming a chartered financial analyst requires the passing of three grueling exams covering an array of topics.
  8. Options & Futures

    The Alphabet Soup of Financial Certifications

    We decode the meaning of the many letters that can follow the names of financial professionals.
  9. Professionals

    How to Ace the CFA Level I Exam

    Prepare to ace the CFA Level 1 exam by studying systematically.
  10. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  4. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  5. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  6. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
Trading Center