Capitalization is an important part of accounting. It affects both financial statements and their ratios. It also contributes to the superiority of earnings over cash flow as a measure of financial performance. This section examines the effects of capitalization (and subsequent allocation) versus immediate expensing for income measurement and ratio computation.
Effects of Capitalization on Income
Capitalization has two effects on income. First, it postpones recognition of expense in the income statement. This means capitalization yields higher income in the acquisition period but lower income in subsequent periods as compared with expensing of costs. Second, capitalization yields a smoother income series. Why does immediate expensing yield a volatile income series? The answer is volatility arises because capital expenditures are often “lumpy” occurring in spurts rather than continually while revenues from these expenditures are earned steadily over time. In contrast, allocating asset cost over benefit periods yields an accrual income number that is a more stable and meaningful measure of company performance.
Effects of Capitalization for Return on Investment
Capitalization decreases volatility in income measures and, similarly, return on investment ratios. It affects both the numerator (income) and denominator (investment bases) of the return on investment ratios. In contrast, expensing asset costs yields a lower investment base and increases income volatility. This increased volatility in the numerator (income) is magnified by the smaller denominator (investment base), leading to more volatile and less useful return ratios. Expensing also introduces bias in income measures, as income is understated in the acquisition year and overstated in subsequent years.
Effects of Capitalization on Solvency Ratios
Under immediate expensing of asset costs, solvency ratios, such as debt to equity, reflect more poorly on a company than warranted. This occurs because the immediate expensing of costs understates equity for companies with productive assets.
Effects of Capitalization on Operating Cash Flows
When asset costs are immediately expensed, they are reported as operating cash outflows. In contrast, when asset costs are capitalized, they are reported as investing cash outflows. This means that immediate expensing of asset costs both overstates operating cash outflows and understates investing cash outflows in the acquisition year in comparison to capitalization of costs.
Effects of Capitalization on Income
Capitalization has two effects on income. First, it postpones recognition of expense in the income statement. This means capitalization yields higher income in the acquisition period but lower income in subsequent periods as compared with expensing of costs. Second, capitalization yields a smoother income series. Why does immediate expensing yield a volatile income series? The answer is volatility arises because capital expenditures are often “lumpy” occurring in spurts rather than continually while revenues from these expenditures are earned steadily over time. In contrast, allocating asset cost over benefit periods yields an accrual income number that is a more stable and meaningful measure of company performance.
Effects of Capitalization for Return on Investment
Capitalization decreases volatility in income measures and, similarly, return on investment ratios. It affects both the numerator (income) and denominator (investment bases) of the return on investment ratios. In contrast, expensing asset costs yields a lower investment base and increases income volatility. This increased volatility in the numerator (income) is magnified by the smaller denominator (investment base), leading to more volatile and less useful return ratios. Expensing also introduces bias in income measures, as income is understated in the acquisition year and overstated in subsequent years.
Effects of Capitalization on Solvency Ratios
Under immediate expensing of asset costs, solvency ratios, such as debt to equity, reflect more poorly on a company than warranted. This occurs because the immediate expensing of costs understates equity for companies with productive assets.
Effects of Capitalization on Operating Cash Flows
When asset costs are immediately expensed, they are reported as operating cash outflows. In contrast, when asset costs are capitalized, they are reported as investing cash outflows. This means that immediate expensing of asset costs both overstates operating cash outflows and understates investing cash outflows in the acquisition year in comparison to capitalization of costs.
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