Accounting

Accounting of Long-lived Assets - Expensing vs. Capitalizing

Long-lived assets refer to PPE, natural resources, and intangible assets.  This section largely focuses on property, plant and equipment (PPE), but there will be some discussion of intangible assets.

PPE on the balance sheet is may be shown on a gross (total amount paid to acquire and ready the equipment for use) and net basis.

  • Gross: Property, Plant, & Equipment
  • Less: Accumulated Depreciation
  • Net: PP&E

Expensing to the income statement vs. Capitalizing to the balance sheet

  • Management typically has some discretion in determining if the cost of an item should be capitalized to the balance sheet and depreciated (or amortized if it is an intangible asset) to the income statement over time or if the cost of the item should be fully expensed to the income statement in the current period.
  • Example: A company may capitalize production facility upgrade investments above $100,000 and expense a facility related purchases below this amount.
  • Capitalization of Interest Expenses: US GAAP and IFRS-IAS provide treatment of the capitalization of interest expenses associated with the construction of long-lived assets.
  • The following table provides examples of the effects on a company’s financial statements and ratios when expensing in-year versus capitalizing in-year.
IMPACTED ITEMEXPENSINGCAPITALIZING
Net Income, Profit Margins, EquityLowerHigher
Asset TurnoverHigherLower
Debt to Equity RatioHigher (Equity is Lower)Lower (Equity is Higher)
ROA and ROELowerHigher

Cash Flows and Expensing vs. Capitalizing of Purchases

  • On a total cash flow basis, the decision to expense or capitalize has no impact because depreciation is a non-cash expense.  However, when Cash Flows are separated by: Operating Activities, Investing Activities, and Financing Activities, the decision to expense or capitalize takes on more meaning.
  • Cash Generated by Operating Activities – when a company expenses an item paid with cash, instead of capitalizing it, the firm will show lower operating cash flows.
  • Cash Generated by Investing Activities – when a company expenses an item paid with cash, instead of capitalizing it, there will be NO CHANGE to investing cash flows.  However, if the company capitalizes the item as a physical investment in PPE, investing cash flows will be lower.
Finance Train Subscription

Unlock full access to Finance Train and see the entire library of member-only content and resources.