LOS b: Compute and describe the effects of capitalizing versus expensing on net income, shareholders' equity, cash flow from operations, and financial ratios, including the effect on the interest coverage ratio of capitalizing interest costs.
For firms that expense rather than capitalize costs, which of the following statements is least accurate?
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Firms that expense costs versus capitalize costs, they will have a lower ROE and ROA in early years because of lower profits and not due to higher assets and equity levels (actually the assets and equity are lower due to expensing the costs).
Meyer Investment Advisory and Smith Brothers Investments are operationally identical except that Meyer capitalizes some costs that Smith expenses. Compared to Smith, Meyer is likely to have:
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The net cash flow remains the same regardless of which accounting method is used. But components of cash flows change and cash flows from operations (CFO) will be higher when costs are capitalized and lower when expensed. On the other hand, cash flows from investing (CFI) will be lower when costs are capitalized and higher when expensed. Compared to firms expensing costs, firms that capitalize costs will have smaller debt to equity ratios and higher initial ROAs, but lower ROAs in the future.
The management of Berger Investments has changed their policy and will capitalize some costs instead of expensing them. Due to the new policy, Berger will:
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If management decides to capitalize costs instead of expensing them, it will report smoother reported income over time. If the firm decided to expense costs as incurred, it will have greater variability in reported income. This variability declines as the firm matures and is lower for larger firms.
When comparing capitalizing versus expensing costs which of the following statements is most accurate?
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Although net cash flows are not affected by the choice of capitalization or expensing, the components of cash flow are affected. Because, a firm that capitalizes classifies the expenditure as investing (not operations), cash flow from operations will be higher for firms that capitalize and investing cash flows will be lower than that of an expensing firm.
Compared to firms that expense costs, firms that capitalize expenses will have:
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Firms that capitalize expenses have less variability of net income because the capitalized expense becomes an asset that is depreciated over years instead of all at once which happens when costs are expensed. Capitalizing expenses will result in higher cash flows from operations because capitalizing an expense becomes an investing cash flow instead of an operating cash flow which occurs when expenditures are expensed. Firms that capitalize expenses have lower leverage ratios because assets and equity are increased so any leverage ratio that have assets and equity in the denominator will decrease.
Which of the following statements regarding the capitalization of an expense is least accurate?
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Capitalizing expenses reduces current period expenses by the amount capitalized. The amount capitalized is added to assets which increases equity by increasing net income and retained earnings in the current period
Dobkin Company decides to expense costs that it would have otherwise capitalized. Compared to capitalizing, expensing these costs will result in:
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Expensing instead of capitalizing results in lower assets. Since the entire expense is recognized in the current period (whereas only a portion of the expenditure is amortized when capitalizing), net income (and therefore equity, via retained earnings) is lower with expensing than with capitalizing. Liabilities are unaffected.
Selected information from Yorktown Corp.’s financial statements for the year ended December 31, 2004 was as follows (in $ millions):
Accounts Payable
8
Long-term Debt
9
Common Stock
17
Retained Earnings
23
Total Liabilities & Equity
57
In 2004, Yorktown paid $10 million cash to purchase a franchise. The franchise cost was fully expensed in 2004. If the company had elected to amortize the franchise cost over 5 years instead of expensing it, Yorktown’s total debt ratio (total debt-to-total capital) would:
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Total capital equals total assets which must equal total liabilities and equity. Yorktown’s total debt ratio was (($8 + $9) / $57 =) 0.298. If the franchise cost were amortized, retained earnings would be increased $8 million ($10 cost less ($10 / 5 =) $2 million of amortization.) The total debt ratio would change to (($8 + $9) / ($57 + $8) =) 0.262.
Selected information from the financial statements of Salvo Company for the years ended December 31, 2003 and 2004 is as follows (in $ millions):
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2003 |
2004 |
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Sales |
$21 |
$23 |
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Cost of Goods Sold |
(8) |
(9) |
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Gross Profit |
13 |
14 |
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Cost of Franchise |
(6) |
0 |
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Other Expenses |
(6) |
(6) |
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Net Income |
$1 |
$8 |
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Cash |
$4 |
$5 |
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Accounts Receivable |
6 |
5 |
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Inventory |
9 |
7 |
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Property, Plant & Equip. (net) |
12 |
15 |
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Total Assets |
$31 |
$32 |
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Accounts Payable |
$7 |
$5 |
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Long-term Debt |
10 |
5 |
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Common Stock |
8 |
8 |
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Retained Earnings |
6 |
14 |
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Total Liabilities and Equity |
$31 |
$32 |
Salvo’s return on average total equity for 2004 was ($8 / (($8 + $6) + ($8 + $14)) / 2 =) 44.4%.
If Salvo had amortized the cost of the franchise acquired in 2003 over six years instead of expensing it, Salvo’s return on average total equity for 2004 would have decreased from 44.4% to:
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If the franchise cost had been amortized over six years beginning in 2003, net income in 2003 would have been $6 million instead of $1 million due to the cost of franchise expense of $6 million being eliminated and replaced by franchise amortization of $1 million. Net income in 2004 would have been reduced by the franchise amortization to $7 million instead of $8 million. On the equity side, retained earnings at the end of 2003 would have been $11 million ($5 million higher), and total equity for 2003 would have been ($8 + $11 =) $19 million. Retained earnings for 2004 would be the 2003 retained earnings of $11 million increased by 2004 net income of $7 million for a total of $18 million, and total equity for 2004 would be ($8 + $18 =) $26 million. If the franchise cost were amortized, return on total equity for 2004 would be ($7 / ((19 + 26) / 2 =) 31.1%.
Compared with firms that expense costs, firms that capitalize costs can be expected to report:
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The capitalized cost is recorded as an asset, which is then expensed in the form of depreciation over future years. Spreading the depreciation out over future years causes net income to increase along with retained earnings and equity in the early years of the asset’s life.
Ironman Nutrition has traditionally followed a conservative policy of expensing most costs. However, the new CFO is an advocate of capitalization. During a meeting with company executives he explains that compared to expensing, capitalization is least likely to result in:
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There is no difference in net cash flow. However, a firm that capitalizes classifies the expenditure as investing (not operations) cash flow from operations will be higher and cash flow from investing will be lower.
The other statements are correct. Capitalizing firms have higher asset and equity levels (due to the booking of the asset and the higher net income.)
A firm that capitalizes rather than expensing costs will have:
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A firm that capitalizes costs classifies them as an investing cash flow rather than an operating cash flow. Investing cash flows will be lower and cash flow from operations will be higher when costs are capitalized.
Train, Inc.’s cash flow from operations (CFO) in 2004 was $14 million. Train paid $8 million cash to acquire a franchise at the beginning of 2004 that was expensed in 2004. If Train had elected to amortize the cost of the franchise over eight years, 2004 cash flow from operations (CFO) would have been:
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If Train decided to amortize the franchise cost, it would be capitalized and $1 million each year would be treated as a reduction in cash flow from investing (CFI). None of the cash expended would flow though CFO, and all of the $8 million would be added back to CFO.
Which of the following statements regarding capitalizing versus expensing costs is least accurate?
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Total cash flow is higher with capitalization than expensing is least accurate because total cash flow would be the same under both methods, not considering tax implications.
Selected information from Willingham Corp.’s financial statements for the year ended December 31 included the following (in $ millions):
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Accounts Payable |
12 |
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Long-term Debt |
32 |
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Common Stock |
10 |
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Retained Earnings |
16 |
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Total Liabilities and Equity |
70 |
During the year, Willingham paid $14 million cash to purchase a franchise and fully expensed the franchise cost. If the company had elected to amortize the franchise cost over 7 years instead of expensing it, Willingham’s total asset-to-equity ratio would be closest to:
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Given that total assets must equal total liabilities and equity, Willingham’s total asset-to-equity ratio was 70 / (10 + 16) = 2.69. If the franchise cost were amortized, retained earnings would be $12 million higher ($14 million cost less 14 / 7 = $2 million of amortization). The total asset-to-equity ratio would decrease to (70 + 12) / (10 + 16 + 12) = 2.16.
Income statement information for Quick Corp. for the years ended December 31, 20X0 and 20X1 was as follows (in $ millions):
20X0
20X1
Sales
30,000,000
32,000,000
Cost of Goods Sold
(16,000,000)
(17,000,000)
Gross Profit
14,000,000
15,000,000
Amortization of Franchise
(1,500,000)
(1,500,000)
Other Expenses
(7,000,000)
(7,000,000)
Net Income
5,500,000
6,500,000
Quick acquired a franchise in 20X0 for $15,000,000 and elected to amortize the cost over 10 years. Ignoring taxes, if Quick had expensed the franchise cost in 20X0 instead of amortizing it, net income for 20X0 and 20X1 would be:
20X0
20X1
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If the franchise cost were expensed, amortization would be eliminated and franchise expense would be fully taken in 20X0. 20X0 net income would be $5,500,000 + 1,500,000 - $15,000,000= -$8,000,000, and 20X1 net income would be $6,500,000 + $1,500,000= $8,000,000.
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