Home > Accounting, CFA L2, fundamental analysis > Implications for Financial Statements & Ratios of Capitalizing vs Expensing Long Lived Assets

Implications for Financial Statements & Ratios of Capitalizing vs Expensing Long Lived Assets

Summary of new* reading in 2011– Implications for Financial Statements & Ratios of Capitalizing vs Expensing Long Lived Assets (longish…even after dividing chapter in 2 parts)

CFA Level 2 – Financial Reporting & Analysis

Study Session 5, Reading 22 in textbook

*(Like the last post, I am certain I have read some of this material before… and it was in 2009 Level 1 – reading 36 in SS9!)

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Terminology & Formula

1. I/S = Income Statement, B/S = Balance Sheet, C/F = Statement of Cash Flows

2. Ending shareholders’ equity = Beginning shareholders’ equity

+ Net income

+ Other comprehensive income

– Dividends

+ Net capital contributions from shareholders

3. Return on Equity (ROE) = Net Income ÷ Average Shareholder’s Equity

4. Interest Coverage Ratio = EBIT ÷ Interest Expense

5. Operating Income = EBIT = EBITDA – Depreciation – Amortization

6. EV/EBITDA = Enterprise Value ÷ EBITDA

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Capitalizing vs. Expensing

Source: Kaplan Schweser Level 1 Curriculum 2009

Adding few more items not in the above table…

Capitalizing Expensing
Profitability Ratios Less Volatile More Volatile
Profitability Ratios, Shareholders Equity, Higher in 1st Year 

Lower in later yrs

Lower in 1st Year 

Higher in later yrs

Market Multiples (P/E, P/CFO, etc) Lower Higher
  1. If a company continues to purchase & capitalize increasing amounts of assets each year, the profitability-enhancing effect of capitalizing continues as long as capital expenditures are more than the depreciation expense.
  2. Because capitalizing increases cash flow from operations, companies may try to maximize CFO by capitalizing expenditures

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Capitalizing Interest Costs

  1. Asset for own use (e.g. own building) – capitalize interest expensed over time as depreciation on b/s
  2. Construction Asset for sale (e.g. construction of building for sale) – capitalized interest appears as part of inventory & is expensed as cost of sale when asset is sold
  3. Adjust EBIT & Interest expense due to capitalized interest when calculating Interest Coverage Ratio

a. adjusted EBIT = EBIT + depreciation due to capitalized interest

b. adjusted Interest = Interest + Capitalized Interest

——————————-

Capitalizing Internal Development Costs (from CFA text)

  1. Research costs to develop intangible assets are generally expensed when incurred
  2. Software development costs are expensed until product’s technological feasibility is established, & capitalized after that

Adjusting Financials for comparison

If a company capitalizes software development costs, adjust:

  1. I/S – include software development costs as an expense and to exclude amortization of prior years’ software development costs
  2. B/S – exclude capitalised software by decreasing assets and equity
  3. C/F – decrease CFO and CFI by the amount of the current period development costs

one more part to this chapter… capital vs operating lease

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  1. June 5, 2011 at 9:35 PM
  2. October 13, 2014 at 5:00 PM

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