Effects of Capitalization & Depreciation on Financial Statements

Brief Concept:

Companies are required to decide whether to capitalize an expenditure or whether to write-off the costs as part of expenses. The decision is based on longevity of asset and depends on assessment of receiving benefits out of the expenses over a period of time. CFA exam will test candidates about knowledge on effect of capitalization vis-à-vis expensing specific cost elements on the income statement and balance sheet of a firm. Candidates are also required to understand the scenarios in which a specific cost is capitalized or expensed.

Key learning out of LOSs as per CFA Curriculum:

Capitalization

• The costs of acquiring resources that provide services over more than one operating cycle are capitalized and carried as assets on the balance sheet. The decision to capitalize or expense some items depends on management choices and is subject to manipulation.

• Capitalization of outlays, compared to expensing, causes lower variability of net income, higher net income, higher operating cash flow, and lower leverage ratios.

• Capitalization causes return on assets (ROA) and return on equity (ROE) to be higher in the year of capitalization and lower in later years unless capitalized expenditures are increasing.

• Capitalization of interest causes interest expense to be lower, depreciation to be slightly higher, cash flow from operations to be higher, and the interest coverage ratio to be higher. Analysts often adjust financial statements to remove the effects of capitalized interest.

• In general, intangible asset costs are capitalized when the assets are acquired from an outside entity. Under U.S. CAAP, only the legal fees to obtain a patent or trademark internally can be capitalized, and development costs for software for external sale may be capitalized after technical and economic feasibility have been established.

• Under IFRS, development costs and interest costs associated with borrowing to acquire or construct specific assets may be capitalized.

Depreciation & Impairment:

• The underlying principle of depreciation is that cash flows generated by an asset over its life cannot be considered income until provision is made for the asset's replacement.

Depreciation Expense = (Original Cost – Salvage Value) / Depreciable value

• Depreciation methods include straight-line and accelerated methods, units of production and service hours methods, and the sinking fund method.

• Compared to straight-line methods, accelerated methods decrease operating earnings and net income in the early years of an asset's life and increase them in the later years.

• The choice of depreciation method on the firm's financial statements does not affect the firm's cash flow, but the use of accelerated depreciation methods for tax reporting lowers taxable income and taxes due, increasing the firm's cash flow by the reduction in taxes.

• A change in accounting method requires a restatement of prior income and an adjustment on the income statement for the cumulative after-tax effect of the change.

• Longer estimates of useful lives and higher estimates of residual asset values both reduce depreciation expense and increase reported earnings.

• Using balance sheet items, an analyst can estimate average age and average depreciable asset lives and can estimate the relative age of the assets when straight-line depreciation is used.

• Impairment must be recognized when the carrying value of an asset is higher than the sum of the future cash flows from their use and disposal.

• Impairment will cause income, asset value, deferred taxes, equity and future depreciation to decline, resulting in an increase in future net income.

• SFAS 143 requires capitalization of environmental remediation expenses and for most firms will lead to higher assets, liabilities, depreciation expense, and interest expense, which will tend to decrease net income. ROA, asset turnover, and interest coverage ratios will all decrease and liabilities -to- equity will Increase.

Type of questions expected in the topic area:

The typical questions expected from this topic area include calculation of

• Which specific cost elements can or cannot be capitalized for a firm

• Differentiation between capitalization effect on legal costs / technological feasibility software etc., in US GAAP or IFRS

• Effect on income by following different methods of depreciation

• Estimating value of depreciation in a specific year and salvage value given a specific method of depreciation