Question on expensing versus capitalizing. Reading 18 questi versus, confusion, question, Classic

andytrader

Hello, thanks for reading. Classic confusion where I think the curriculum is contradictng itself but its probably user error. In Reading 18, they talk about expensing versus capitalizing. They talk about expensing leading to lower net income/ profit margin because of the higher expenses (question 1 in the problem set). Then, they talk about how capitalizing results in lower profits because the lease expense (if it were an operating lease vs a finance lease) is less than the combined depreciation plus interest costs (for the finance lease). As far as I can tell, both deal w the perspective of the lesseee, so I didnt screw that one up. And thay didnt provide numbers, so it was conceptual versus calculating the exact tax etc effect.
Is there a different consideration between expensing vs capitalizing an asset and operating vs finance lease? I would think the process would be the same effect on the is (expensing equivalent to operating lease and capitalizing equivalent to finance lease), but maybe I am wrong
answer to 1:
C is correct. Expensing rather than capitalising an investment in long-term assets will result in higher expenses and lower net income and net profit margin in the current year. Future years’ incomes will not include depreciation expense related to these expenditures. Consequently, year-to-year growth in profitability will be higher. If the expenses had been capitalised, the carrying amount of the assets would have been higher and the 2009 total asset turnover would have been lower.
Answer to 9:
is correct. The cash flow from operating activities will be lower, not higher, because the full lease payment is treated as an operating cash outflow. With a finance lease, only the portion of the lease payment relating to interest expense potentially reduces operating cash outflows. A company reporting a lease as an operating lease will typically show higher profits in early years, because the lease expense is less than the sum of the interest and depreciation expense. The company reporting the lease as an operating lease will typically report stronger solvency and activity ratios.

Valores

question 1
a) It can’t be a) because net profit margin is lower if they had been expensed. the expense is for the current period and would hit PNL straight away.
b) It can’t be b) because total asset turnover is higher because capitalising an asset would make total assets go up, which would mean you’re dividing by a higher base.
c) Yes. because the future profit growth will be hampered by depreciation as you capitalised it and added it to the asset base. Expensing means you deal with it right now and nothing else should come about from it.
question 9
a) Jordan is right with a) because the interest cost associated with the repayments will outweight the rental expense. this will wear down as the years go on as interest is less.
b) Jordan is right. because finance assets are brought onto the balance sheet via a liability (the debt they have to pay) and the asset (depreciation expense). this means that solvency ratios will be lower.
c) Jordan is wrong because full rental expense is recognised as OCF while the interest portion of the finance lease is recognised as OCF. the principal payment i think is a result of financing acitivities.

bkballa

I think the confusion arises due to capital lease vs. capitalizing expense - 2 different things.

SFoyil

if you capitalized an expense - you would have a higher asset base, a depreciation expense each period instead of a big expense in this current period.
so in the year of expensing the asset - you would have a lower net income vs. if you had capitalized the same.
So NI(Expensing)
Now Asset(Expensing)  
Total Asset Turnover = Net Sales / Total Assets.
Assuming Same level of Sales - since Asset(Expensing)