Sunday 8 January 2012

Capitalizing vs Expensing Interest - Level II FRA (Reading 21)

According to IFRS, the cost of an item of PPE shall be recognized as an asset if and only if:
a) It is probable that future economic benefits associated with the item will flow to the entity; and
b) The cost of the item can be measured reliably.
U.S. GAAP has similar rules.

Examples of PPE include:
· Land
· Buildings
· Machinery
· Furniture
· Fixtures
· Vehicles
· Major spare parts that are expected to be used
during more than one period.
· Major spare parts that can be used in connection
with an item of PPE.

Examples of Expenditures to get an asset ready for its intended use include:
· Purchase price
· Delivery
· Installation
Intangible Assets:
Intangible are assets which do not have physical substance.

Requirements under IFRS & U.S. GAAP include:
Intangible assets must be
· Identifiable,
· Under the control of the entity, and
· Generators of future economic benefits

· When assets are acquired as part of a business combination then each identifiable tangible and intangible asset is recorded by a company at estimated fair values.
· If the purchase price > sum of the amounts allocated to identifiable assets and liabilities, then the excess is recorded as goodwill.

Effects of capitalization of expenditure:
In the period of expenditure, an expenditure that is capitalized:
· Increases the amount of assets on the balance sheet.
· Appears as an investing cash outflow on the statement of cash flows.
· Higher profitability compared to expensing in the first year.
· Higher Shareholders’ equity compared to expensing in the first year.
· Results in higher ROA & ROE initially.
· ROA and ROE will be lowered in subsequent years as net income is reduced by depreciation expense.
· Results in lower Debt-to-equity and debt-to-assets ratio (lower leverage) due to higher assets and higher shareholders’ equity.
· Results in greater amounts reported as cash from operations.
· The profitability-enhancing effect of capitalizing continues so long as capital expenditures > depreciation expense.

In subsequent periods,
· Capitalized amount is allocated over the asset’s useful life as depreciation or amortization expense.
Note: land is not depreciated. Intangible assets with indefinite lives are not amortized.
· Depreciation/amortization expense reduces net income (NI) on the income statement and the value of the asset on balance sheet.
· Depreciation and amortization are non-cash expense and have no impact on the cash flow statement.

· Lower profitability compared to expensing in the subsequent years.

Effects of Expensing the expenditure:
When expenditure is expensed:
· No asset is recorded on the balance sheet in the period of expenditure.
· Reduces net income by the after-tax amount.
· The lower amount of NI is reflected in lower Retained earnings on the balance sheet.
· Appears as an operating cash outflow on the statement of cash flows.(lower operating cash flow)
· No depreciation/amortization occurs in subsequent periods.
· Lower profitability compared to capitalizing in the first year.
· ROA and ROE will be lower initially but higher in subsequent years.
· Higher profitability compared to capitalizing in subsequent years.
· Lower EBITDA.
· Higher Market Multiples…..due to which a stock might appear overvalued.
· Market-based ratios should be adjusted for capitalized costs in order to have a better basis for comparison.

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