MMS- I (Sem I) Financial Accounting Prof.

Gazia Sayed

Long-lived assets include :

Tangible assets, Intangible assets and Financial assets
Long Lived assets are also called as : Fixed Assets Long term assets

Distinguish between costs incurred :

When a firm makes an expenditure, it can either capitalized the cost as an asset on the balance sheet or expense the cost in the income statement in the period incurred. As a general rule, an expenditure that is expected to provide a future economic benefit over multiple accounting periods is capitalized; however, if the future economic benefit is unlikely or highly uncertain the expenditure is expensed in the period incurred.

Cont....
An expenditure that is capitalized is initially recorded on the balance sheet at cost, typically its fair vale at acquisition plus costs necessary to prepare the asset for use. All the subsequent related expenditures that provide more future economic benefits (e.g. rebuilding the asset) are also capitalized. Any subsequent expenditure that merely sustain the usefulness of the asset (e.g. regular maintenance) are expensed when incurred.

Cont....
Except for land and intangible assets with indefinite lives (such as acquisition of goodwill), the cost is then allocated to the income statement over the life of the asset as depreciation expense (tangible assets) or amortization expenses (intangible assets) If an expenditure is immediately expensed, than current period pretax income is reduced by the amount of the expenditure.

Effect of capitalization versus expensing

The choice between capitalizing the costs and/or expensing them will affect : the net income, shareholders equity, total assets, cash flow from operations, cash flow from investing and numerous financial ratio

Effect on Net Income

Capitalizing an expenditure delays the recognition of an expense in the income statement. Thus, in the period that an expenditure is capitalized, the firm will report higher net income compared to immediately expensing, as the capitalized expenditure is allocated to the income statement through depreciation expense. This allocation process reduces the variability of net income by spreading the expense over multiple periods.

Cont....
Conversely, if a firm expenses an expenditure in the current period, net income is reduced by the after-tax amount of the expenditure. In subsequent periods, no allocation of cost is necessary. Thus, net income in future periods is higher than if the expenditure had been capitalized. Over the life of an asset, total net income is identical whether the asset's cost is capitalized or expensed. The only difference is in timing of the expense recognition in the income statement.

Effect on Shareholders Equity

As capitalization results in higher net income in the period of the expenditure compare to expensing, it also results in higher shareholders equity because retained earnings are greater. Total assets are greater with capitalization and liabilities are unaffected, so the accounting equation (A=L+E) remains balanced. As the cost is allocated to the income statement in subsequent periods, net income, retained earnings, and shareholders equity will be reduced. If the expenditure is immediately expensed, retained earnings and shareholders equity will reflect the entire reduction in the net income in the period of the expenditure.

Effect on Cash Flow

A capitalized expenditure is usually reported as an outflow from investing activities. If immediately expensed, the expenditure is reported as an outflow from operation activities. This, capitalizing will result in higher operating cashflow and lower investing cashflow compared to expensing.

Effect on Financial Ratios

Capitalizing results in higher assets and higher equity compared to expensing. Thus, both the debt/assets ratio and the debt/equity ratio are lower. Capitalizing will initially result in higher Return on Assets and higher Return on Equity. This is the result of higher net income in the first year. In subsequent years, ROA and ROE will be lower because net income is reduced by the depreciation expense.

Cont....
Expensing the entire expense in the first year will lower the ROA and ROE in the first year and will be higher in the subsequent years. An analysts must be careful when comparing firms, because immediately expensing an expenditure gives the appearance of growth after the first year.

Capitalized the Interest

An interest incurred during the construction period is capitalized as a part of the assets cost and is not reported in the income statement as interest expense. Capitalized interest is reported in the cash flow statement as an outflow from investing activities, while interest expense is reported as an outflow from operating activities. If the interest expense is capitalized, than the interest coverage ratio (EBIT/interest expenses) will be higher.

Financial Statement Effects Capitalizing vs. Expensing

Capitalizing Total Assets Shareholders Equity Income variability Net income (first year) Net income (subsequent years) Cashflow from operations Higher Higher Lower Higher Lower Higher Expensing Lower Lower Higher Lower Higher Lower

of

Cashflow from investing

Debt /asset ratio and Debt/equity Interest coverage (first year) Interest coverage (subsequent years)

Lower
Lower Higher Lower

Higher
Higher Lower Higher

Example
AB Ltd. purchased a new equipment to be used in its manufacturing plant. The cost of the equipment was Rs.2,50,000 and it incurred Rs.10,000 on freight and Rs.5,000 on loading and unloading the equipment. AB Ltd. also incurred Rs.12,000 to install the equipment and Rs.7,500 to train its employees to use the equipment. Over the assets life, AB Ltd. paid Rs.35,000 for repair and maintenance. What amounts should be capitalized on AB Ltds Balance Sheet and what amounts should be expensed in the period incurred?

Solution
Capitalized Cost : Purchase Price of the equipment = Rs. 2,50,000 Freight charges = Rs. 10,000 Loading and unloading charges = Rs. 5,000 Installation Cost = Rs. 12,000 Total Cost = Rs. 2,77,000 Costs Expensed when incurred : Initial Training costs = Rs. 7,500 Repair and maintenance = Rs. 35,000 Total Cost = Rs. 42,500

Example
At the end of 5 years, AB Ltd. extended the life of the asst by rebuilding the equipments motors at a cost of Rs.80,000.
Whether the amount be capitalized on AB Ltds Balance Sheet or would be expensed in the period incurred? Answer : Capitalized