Capitalizing vs. Expensing understand, statements, different, following, capital

sweetgirl

I thought I understand capital lease but keep getting different explanations from schweser questions.

Which of the following statements about capitalizing and expensing the cost of a lon-lived asset least accurate?

A. A company that capitalizes the cost will have lower debt-to-asset and debt-to-equity ratios than a company that expenses the cost
B. A company that expenses the cost will show the same total cash flows as the capitalizing firm, but will show higher profitability early in the asset's life.
C. In the early years of the asset's life, a company that expenses the cost will have lower profitability ratios, such as return on assets and return on equity, than a company that capitalizes the cost.

The answer is B, can someone please explain? I thought in the early years on capital lease, ROE is lower.

agulani

Chung- Thanks, so how come B is not true? I think the answer is C. This is question 61 of the vol 1 exam 2 afternoon test. I checked errata, doesn't see this.

johnnyBuz

Heres a summary dude i hope this helps

CAPITAL LEASE
Balance sheet: Record Asset and Liability. Current Assets are the same but Non Current Assets increase. So does Current Liability and Long Term Debt pending on the lease strructure.

Income Statement: Record interest expense & Depreciationed, Total expenses earlier years is higher thus profits will be lower

Statement of Cashflow: Chashflow is split between operating and finance, Thus CFO is higher because cashflow from operations is lower

OPERATING LEASE
Balance Sheet: NO ENTRY Thus assets and liabilities are lower relative to capital lease

Income Statement: Record Rent Expense

Statement of Cashflows: Entire lease payment is under CFO thus CFO will be lower relative to capital lease

RATIOS ANLYSIS FOR CAPITAL VS OPERATING (Early Years)
Net Profit Margin : Net Income/Sale thus under capital lease Net income will be lower so operating lease will show a higher Net Profit margin (In the earlier years)

Return On Equity: Net Income/Equity, Net income goes down thus capital lease will be lower realtive to operating (In earlier Years)

Asset Turnover: Sales/Assets, Assets up this ratio will be lower under a capital lease

Interest Coverage: Ebit/Int expense, Interest expense up therefore Interest coverage will be lower for a capital lease.

sdada

Chung - based on your explanation do you agree that answer C is least accurate and schweiser is wrong - you wrote "Return On Equity: Net Income/Equity, Net income goes down thus capital lease will be lower realtive to operating (In earlier Years)" which contradicts C and B is actually an accurate explanation.

dotamasta

Now that I think about it, answer is indeed B.

Option A

Expensing the cost will have no effect on the liability (debt) side of the balance sheet but will decrease asset (reduction of cash) and equity. And so Debt-to-asset and debt-to-equity will both increase. Decreased denominator. For capilized firm, it'll be the opposite effect. So this statement is accurate.

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Option B

Expensing the cost will show a higher profitability early in the asset's life is wrong, because expensing the cost will have a higher impact on net income as opposed to capitalizing it. So this statement is the least accurate, although the first part of the statement is accurate in that both firms will have the same TOTAL cash flows over the life of the asset.

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Option C

Expensing the cost will have a lower profitability ratio because of reduced net income...etc. So this option is accurate.

rkapoor

Damm - this is not a capital lease ? it is just a capitilizing ? I see now

rgonzalez

I think both A and B are not accurate.

A - least-er because both debt-asset will be higher. And Debt to Equity will be higher capitalized. (as Damil pointed out)

B - Cash flow portion accurate. But profit margins not accurate.

So A qualifies as least accurate I guess.

comment



Edited 1 time(s). Last edit at Wednesday, June 3, 2009 at 11:44AM by ov25.

ftwcfa

C is wrong A firm that expenses the cost is under an operating lease. Thus in the earlier years your profit margin and return on assets/equity will be higher. for operating lease. Answer B is wrong becaseu Cash flow from operations will be different under the two metheds One will be overstated and one will be understated. The thing is C is also wrong.

The key to understanding operating vs cpaital is that in the earlier years capitla lease expenses are greater than operating expenses

Interest expense + Depreciation expense > rent expense.

Is there a typO here?



Edited 2 time(s). Last edit at Wednesday, June 3, 2009 at 11:50AM by chung.da.neu.

dece2011

slorte Wrote:
-------------------------------------------------------
> I saw another post that confused "capitalizing" w/
> "capital lease"
>
> they are not the same thing.
>
> there are TWO different animals here -
>
> 1. Capitalizing vs. Expensing - "capitalizing"
> means you spread out the expense over a period of
> time (smoothing out), expensing means you
> recognize the entire expense in the current
> period. Check out R&D and software development
> examples for these topics.
>
> 2. Operating Leases vs. Finance (capital) leases -
> are two different treatments for leases that
> *only* apply to leases and nothing else.
>
> Chung's post is accurate and good at explaining
> lease treatments, but its not what the question is
> asking.
>
>
>
>
> the answer is B because a company that expenses
> costs will show LOWER profitability in the early
> part of the asset's life due to HIGHER expense
> being reported.


+1. I agree. This question is about capitalizing versus expensing. That makes B the correct answer.

chetan86

I saw another post that confused "capitalizing" w/ "capital lease"

they are not the same thing.

there are TWO different animals here -

1. Capitalizing vs. Expensing - "capitalizing" means you spread out the expense over a period of time (smoothing out), expensing means you recognize the entire expense in the current period. Check out R&D and software development examples for these topics.

2. Operating Leases vs. Finance (capital) leases - are two different treatments for leases that *only* apply to leases and nothing else.

Chung's post is accurate and good at explaining lease treatments, but its not what the question is asking.




the answer is B because a company that expenses costs will show LOWER profitability in the early part of the asset's life due to HIGHER expense being reported.