capitalize expenditure v.s. expensing...
So I am using Kaplan's book studying CFA level 1.
It says: "capitalizing an expenditure results in higher assets and higher equity compared to expensing. Thus, both the debt to assets ratio and the debt to equity ratio are lower with capitalization."
I understand that capitalizing an expenditure results in higher asset, since firm gets to use it for sometime..but I thought it will increase liability, since firm needs to make annual payment. I don't understand why it increases equity. On the other hand, wikipedia seems to be more supportive of me...
"Since a finance lease is capitalized, both assets and liabilities (current and long-term ones) in the balance sheet increase. As a consequence, working capital decreases, but the debt/equity ratio increases, creating additional leverage." http://en.wikipedia.org/wiki/Finance_lease
which one is right??? and why.....
The equity increases because of the additional retained earnings. When you capitalize an asset, your net income is HIGHER, so more goes into stockholders equity. By contrast, when you expense an asset, your NI is LOWER and (but CF is higher due to lower taxes paid).
Is that clear?
I got the equity part now...but why liability is held constant?
To confuse you even more, I will tell you that both wikipedia and you CFA study guide are correct. Let me explain:
Wikipedia is talking about capital leases. If you lease equipment then you normally record the following journal entry (operating lease):
dr. rent(equipment) expense xx cr. cash xx
No liability recorded here, which is more beneficial accounting for companies than buying the equipment. But if you lease equipment for most of its useful life (there are four tests to determine this status) then you are virtually buying the equipment and have to capitalize the lease:
dr. leased equipment xxxx this is an asset cr. lease liability xxxx liability
wikipedia is saying that debt/equity is higher NOT compared to using operating lease method, but rather when compared to doing nothing at all, i.e. debt/equity before the transaction.
Now your CFA guide is talking about capitalizing expenditures. Lets say you buy equipment (pay cash with no lease obligation). If you expense it then:
dr. equipment expense xxxx (lowers retained earnings) cr. cash xxxx (lowers assets)
If you were to capitalize that purchase instead you would book:
dr. equipment xxxx (increase assets) cr. cash xxxx (lowers assets)
So this entry has no net effect on your assets or balance sheet at all. When you compare the two you can see that capitalizing has higher assets and equity as compared to expensing (which decreases both assets and equity), and therefore you have lower debt to equity and debt to assets as compared to expensing. But when you compare it to not doing anything (pre transaction) then there would be no change in those ratios, but expensing would decrease the ratios.
I hope this helps.
@moneykingdom - don't get me started on taxes and cash flows again, because we just had a heated discussion on that topic in the "why LIFO higher cash flow?" thread. LOL!
Remember that accounting isn't cash accounting - that's why your intuition is just a little off.
If you go buy a piece of equipment for 50,000 - you have to pay the dealer 50,000 that day assuming no financing. So your cash flow is -50,000. If you expense it, you NI will reflect the -50,000 in that period. However if you capitalize it, you take the non cash depreciation expense over 5 years which will lower NI by only 10,000 per year for 5 years (assuming straight line, 5 year life, no resid value). You're out the cash no matter what but your NI is different from change in cash flows.
stk123..ur explanation is very clear!! Thanks a lot!
Capitalizing vs. Expensing (Originally Posted: 01/26/2015)
I am trying to calculate adjusted EBITDA for a client at my internship; however, I'm running into a problem with capitalizing versus expensing an expense. The company expensed their capital expenditure in 2014 and my MD told me to calculate the amount that should have been expensed if it were treated as capex on the cash flow statement for the year. We work with very small companies so I am working with tax returns. Does anyone have an idea on how to best approach this and come up with a number?
Thank you, looking forward to hearing your thoughts!
vdubben
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