Level 1 CFA® Exam:
Capitalizing vs Expensing
A long-lived asset is an asset that is expected to generate future economic benefits for more than one year. So, a long-lived asset must meet all conditions necessary to recognize it as an asset and the expected future economic benefit from the asset should exceed one year.
One of the problems related to long-lived assets is how we should include acquisition costs of long-lived assets in books. The question is whether these costs should be recognized immediately in the first period or whether they should be allocated over more periods? Well, both solutions are allowed if certain conditions are met.
Hence, the costs of acquiring long-lived assets can be divided into:
- costs that are capitalized, and expensed in future periods or
- costs that are expensed as incurred.
If the cost of a long-lived asset is capitalized, it means that after the acquisition we recognize an asset. In the subsequent periods, we reduce the value of the asset until the end of the asset’s useful life or until we sell the asset.
In other words, we spread the cost of the asset over future periods. The expenditure will be capitalized when it is clear that the cost will benefit future revenue. So, for example, if the company purchases equipment with a useful life of ten years, the cost of the equipment will be capitalized.
However, not always can we be sure whether the cost will benefit future revenue indeed. This will happen when a given expenditure does not fulfill asset recognition criteria. In such situations, costs related to long-lived assets are not capitalized, but rather expensed as incurred. This also means that such costs are reported in the income statement in their full amount.
So, remember we can either capitalize the expenditure as part of the cost of the asset, or we can expense it right away.
If the cost is capitalized, it is included in the income statement as depreciation or amortization later on. In the case of tangible assets, we talk about depreciation, while in the case of intangible assets with a finite useful life, we talk about amortization.
Of course, there are also intangible or tangible assets that are not amortized or depreciated. These include for example goodwill and land. We will discuss depreciation and amortization in the next lesson in more detail.
Note: the choice of cost allocation affects the financial statements of the company.
Acquisition Cost of Tangible Long-Lived Asset
Acquisition cost of a tangible long-lived asset is equal to purchase price plus delivery charges plus installation costs. If we purchase a tangible long-lived asset, we usually capitalize the total cost and then reduce the asset’s value by the depreciation expense over the next years.
What about ongoing costs? It depends.
Ongoing cost is expensed in a given period if it is related to the maintenance of the asset. On the other hand, if ongoing costs result either in:
- an extension of the useful life of an asset, or
- an increase in the value of an asset,
they are usually capitalized.
Costs of Assets Developed Internally
If the company creates an asset, among acquisition costs we will include:
- raw materials,
- labor, and
- the interest on debt used to finance the construction of the asset, for example, a building.
If the company takes a loan to finance the construction of a building, the interest will be capitalized over the period of time in which the building is being erected. Note, however, that there is a subtle difference between IFRS and U.S. GAAP here.
According to IFRS, money from the short-term investing of the loan proceeds during the construction of the building reduces the amount of borrowing costs capitalized as part of the asset cost. According to U.S. GAAP – it doesn’t.
We will examine the process of interest capitalization both under IFRS and under U.S. GAAP in the example:
On 1 June 2019, Gringo Inc. took a loan to finance the construction of a plant. The term of the loan was 10 years and the company borrowed PLN 50 million. The table presents interest payments for each year over ten years:
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
|---|---|---|---|---|---|---|---|---|---|---|
| Interest payment (PLN in millions) | 4.2 | 3.8 | 3.4 | 3.0 | 2.5 | 2.0 | 1.4 | 0.8 | 0.2 | 0.1 |
The construction started on 1 June 2019 and ended on 31 May 2022. Over this time, the company’s annual effective rate from short-term investing of the loan was equal to 1.2%. The second table provides information related to the investment of the loan proceeds:
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
|---|---|---|---|---|---|---|---|---|---|---|
| Amount invested (PLN in millions) | 30 | 10 | 4.5 | 0 | 0 | 0 | 0 | 0 | 0 | 0 |
What is the total amount of capitalized interest both under IFRS and under US GAAP?
(...)
Note: If interest is capitalized, the interest coverage ratio will be higher than if interest is recognized as an expense. This is due to lower financial costs. This situation occurs only in the first period. In the subsequent periods, the situation is reversed, which means that the interest coverage ratio is lower.
These aspects of interest capitalization should be taken into account when analyzing financial statements of different companies or when analyzing a company’s credit situation. This is why you should pay special attention to assumptions and data used to calculate the interest coverage ratio.
We will analyze the costs of intangible assets for 3 different situations:
- First we will assume that an intangible asset is purchased from a third party.
- Then we will assume that an intangible asset is developed internally.
- Finally we will assume that an intangible asset is purchased in a business combination.
Intangible Asset Purchased from Third Party
If the intangible asset is purchased from a third party and the purchase isn’t a part of a business combination, we will use the same rules as in the case of tangible assets. It means that the asset will be recorded at its fair value and the cost of acquisition will be usually capitalized.
Intangible Asset Developed Internally
If the intangible asset is developed internally, we will usually expense the cost as incurred.
(...)
Intangible Asset Purchased in Business Combination
Finally, let’s talk about the cost of intangible assets purchased in a business combination.
For business combinations, an acquisition method is used. The algorithm of this method looks as follows:
- Record the value of every acquired asset at its fair value.
- Sum up the total value of the assets.
- If the purchase price is greater than the sum from Step 2, goodwill is recorded.
Thus, goodwill is the difference between the purchase price and the total fair value of acquired assets.
Under IFRS, an asset will be included in goodwill if it cannot be recognized as:
- a tangible asset, or
- an identifiable intangible asset.
According to U.S. GAAP, an intangible asset will be included in goodwill if it:
- doesn’t arise from contractual or legal rights, and if it
- cannot be separated from the acquired company.
We will now proceed to discuss the impact of capitalizing and expensing on some selected items of financial statements. Look at the example.
We have 2 companies: W&A, Inc. and Ex-Me, Inc.
Assume that for two subsequent years, both companies will report:
- annual revenue of USD 6,000,
- operating costs amounting to USD 2,000, and
- the income tax rates of 20%.
Additionally, both companies decided to purchase equipment that costs USD 2,400 at the beginning of the first year.
Company W&A Inc. uses straight-line depreciation and estimates the useful life of the equipment to be 2 years and its residual value to be 0.
The management of Ex-Me Inc. assumes that the useful life of the equipment will be shorter than one year. Both companies will not make any additional purchases within the next two years.
How will the balance sheet, income statement, and cash flow statement look like for both companies in the coming two years?
Assume that all earnings are distributed to shareholders in the form of a cash dividend.
(...)
Summary of the Impact
As you can see, if we capitalize an expenditure, we will get a higher net profit than if we expensed this expenditure as incurred. However, this applies only to the first period. In the next period, the net profit is lower due to the allocation of the cost in the income statement in the form of depreciation.
Now we will analyze the impact of capitalizing and expensing on equity. For this purpose, let’s assume that companies don’t pay dividends. Then, any changes in equity come as a consequence of changes in net profit. In the case of capitalizing, higher net profit in the first year translates into higher equity. In subsequent years, however, the equity increases less because of lower net profit.
As far as the cash flow statement is concerned, the choice of the appropriate method of allocating costs translates into a different classification of cash flows and different timing. In the case of capitalizing, in the first period, there is a cash outflow from investing activities and we deal with a higher cash flow from operating activities. Remember, however, that the total value of the cash flows during the useful life of the asset is equal in both cases.
If we capitalize an expenditure, we will get an increase in the values of assets and equity as compared to expensing the expenditure. So, for example, the debt ratio and the debt to equity ratio are lower. In turn, a higher level of net income in the first period results in a higher return on assets and a higher return on equity. In subsequent periods, however, due to allocating expenses in the form of depreciation, both ratios will be lower for capitalizing rather than for expensing.
- The cost of acquiring a long-lived asset can be either expensed as incurred or capitalized.
- If the cost of a long-lived asset is capitalized, it means that after the acquisition we recognize an asset.
- When a given expenditure does not fulfill asset recognition criteria, costs related to long-lived assets are not capitalized, but rather expensed as incurred.
- If the cost is capitalized, it is included in the income statement as depreciation or amortization later on.
- Acquisition cost of a tangible long-lived asset is equal to purchase price plus delivery charges plus installation costs. The ongoing cost is expensed in a given period if it is related to the maintenance of the asset.
- If the company creates an asset, among acquisition costs we will include: raw materials, labor, and the interest on debt used to finance the construction of the asset, for example, a building.
- According to IFRS, money from the short-term investing of the loan during the construction of the building reduces interest expense recognized as part of the asset cost. According to U.S. GAAP – it doesn’t.
- If the intangible asset is purchased from a third party and the purchase isn’t a part of a business combination, we will use the same rules as in the case of tangible assets.
- If the intangible asset is developed internally, we will usually expense the cost as incurred.
- According to U.S. GAAP research and development costs are usually expensed as incurred. The only exception are costs related to software development.
- According to IFRS, research costs are expensed as incurred, but development costs can be capitalized in many more cases than it is allowed by U.S. GAAP.
- For business combinations, an acquisition method is used.
- Goodwill is the difference between the purchase price and the total fair value of acquired assets.
- While analyzing the effects of capitalizing and expensing, we should pay particular attention to the differences that may occur in financial statements, such as the cash flow statement, the income statement, and the balance sheet. In the case of capitalization, we deal with higher values of assets and equity. In addition, in the first period, the net profit is higher, while in the next periods it is lower than in the case of expensing costs as incurred. Cash flows from operating activities is also higher, however, there is an investing outflow.
- For capitalizing, both the debt ratio and the debt to equity ratio are lower.