Difference between Capitalizing and Expensing Costs/Expenditures difference, advantages, understand, only

manchester88

Can someone please break this down in an easy to understand way?? Schweser does a terrible job explaining the difference between Capitalizing costs/expenditures and Expensing them.

This is one of this wtf chapters where you have to read every sentence 3 times only to each time wonder if its going to be on the test.

What is the difference/advantages?

Any suggestions i'm sure will help more than this book.

Thanks

Ionutzakis

allegro-cpa/cfa Wrote:
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> Do you guys have a good synopsis on the
> differences between the different types of leases?
> And effects on the cash flow statement and/or
> ratios.


I am going to use another example to illustrate this.

MT and TME are both construction companies. MT uses operational lease while TME uses financial lease.

MT reaches an agreement with SM Leasing to borrow an equipment for 5 years and is obligated to pay $10m annually as lease payments. This expense will be reflected in the operational section of the income statement. There will be no balance sheet effect. Cash flow statement will show cash outflow in the cash flow from operations section.

TME leased a similar equipment from SM leasing. Let's start from the balance sheet. The present value of the payments will be found by discounting them at interest rate that SM Leasing charges TME. This present value will be added to the liability section of the balance sheet and it will also reflect in the asset section of the balance sheet as an asset. Remember that there is no double counting here because assets are the total value of wealth controlled by the firm and it a combination of what the firm owns (equity) and owes (liabilities). The lease asset will be amortized over five years since the contract is for five years; this amortization will be expensed in the income statement and since this is a non cash expense, it will be adjusted in the cash flow from operations section just like depreciation. The liability that is paid will also flow through the income expense and in the cash flow from financing (please reconfirm) while interest expense paid on the lease will reflect in income statement as interest expense and in cash flow statement as cash outflow from either financing or operating.

This is just a bird's eyeview. Hope it helps and it is important to know when to classify a lease as operating or financing.

Good luck.

siavosh

perfect, I got it now! thanks a lot guys - this forum is great =)

chetan86

I will use an example to illustrate.

MT is a retailer with outlets in China and India. It wants to install solar energy plates in all its outlet. MT has two options - either capitalize the cost or expense it.

Let's start with expensing. MT expenses the cost. Assume this company has no debt and thus pays no interest expense. Cost of goods sold, SG&A, depreciation and other expenses have been deducted and MT has $10m. Cost of opening the new outlet is $8m... after expensing this cost, earnings before tax is not $2m. Assuming that there is no change in earnings and expenses, the following year earnings before tax will be $10m because the outlet had been expensed the previous year. With expensing the income statement takes a major hit in the first year and then profitability jumps the following year. This leads to volatility in earnings which is a disadvantage if such expenses occur intermittently. Balance sheet will show the energy plates as assets that will be depreciated over time. Cashflow statement will reflect the fact the project was expensed (investing cashflow).

Now to capitalization. MT capitalizes the cost. The income statement will not show the expense. The cost will be capitalized and it will show as asset in the balance sheet. Apart from the normal depreciation of the plates that will be expensed through the income statement, the capitalized cost of the energy plates will also be amortized over time through income statement. What this means is that the income statement will not take a hit on the first year unlike expensing but from the second year on, earnings before tax will be lower than that of expensing; this is because while expensing only depreciation will reflect in income statement, capitalizing will reflect both depreciation and amortization of the capitalized cost.

This is just a bird's eye view and I hope you find it helpful.

Good luck.

JPSem

Just remember these two things.

1) Expensed items appear in income statement. Capitalized items appear in balance sheet.
2) When you capitalize the expense, you initially record it in b/sheet & gradually shift it to income statement.

With this simple logic you can break down all other things.