Capitalizing versus Expensing

The costs of acquiring resources that provide services over more than one operating cycle should be capitalized and carried as assets on the balance sheet. All costs incurred until an asset is ready for use must be capitalized, including the invoice price, applicable sales tax, freight and insurance costs incurred delivering equipment, and any installation costs. Costs of the long-lived asset should be allocated over current and future periods. In contrast, if these assets are expensed, their entire costs are written off as expense on the income statement in the current period.

Accounting rules on capitalization are not straightforward. As a result, management has considerable discretion in making decisions such as whether to capitalize or expense the cost of an asset, whether to include interest costs incurred during construction in the capitalized cost, and what types of costs to capitalize for intangible assets. The choice of capitalization or expensing affects the balance sheet, income and cash flow statements, and ratios both in the year the choice is made and over the life of the asset.

Here is a summary of the different effects of capitalization versus expensing:

• Income variability. Firms that capitalize costs and depreciate them over time show "smoother" patterns of reported income. Firms that expense those costs as incurred tend to have higher variability of net income.

• Profitability. In the early years expensing lowers profitability because the entire cost of the asset is expensed. In later years expensing results in higher net income because no more expense is charged in those years. This results in higher ROA and ROE because these expensing firms report lower assets and equity.

• CFO. The net cash flow remains the same, but the compositions of cash flows differ. Cash expenditures for capitalized assets are included in investing cash flows and are never classified as CFO. In contrast, cash expenditures for expensed outlays are included in CFO and are never classified as investing cash flows. Capitalization results in higher CFO but lower investing cash flows, and the cumulative difference increases over time.

• Leverage ratios. Capitalization firms have better (lower) debt-to-equity and debt-to-assets ratios, since they report higher assets and equities.

Capitalization of Interest Costs

Under SFAS 34, interest is capitalized for certain assets and only if the firm is leveraged. Therefore, the carrying amount of a self-constructed asset depends on the firm's financial decisions. The capitalized interest cost is added to the value of the asset being constructed.

The amount of interest cost to be capitalized has two components:

• Any interest on borrowed funds made specifically to finance the construction of the asset. The interest rate applicable is the interest rate on each borrowing.
• The interest on other debt of the firm, up to the amount invested in the construction project. The interest rate applicable is the weighted-average interest rate on all outstanding debt not specifically borrowed for the asset under construction.

Therefore, the total interest cost incurred during the accounting period has two parts:

• Capitalized interest cost, which is reported as part of the asset on the balance sheet. Payments for capitalized interest cost are classified as an investing cash outflow and never as CFO.
• Other interest cost, which is charged to expense on the income statement. Payments for such non-capitalized interest cost are reported as CFO.

The total interest cost, along with the amount capitalized, must be disclosed as part of the notes to the financial statements.

Once the construction is complete, capitalized interest costs will be written off as part of depreciation over the useful life of the asset. From now on, any future interest cost on remaining borrowings made for the construction of the asset must be expensed.

For analytical and adjustment purposes, analysts probably need to expense all interest in self-constructed assets (that is, the income statement capitalization of interest should be reversed).

During the construction period this could result in:

• Lower fixed and total assets, as the capitalized interest would be converted to interest expense.
• Lower net income, as the interest expense would be higher.
• Lower CFO and higher CFI as payments for capitalized interest would be classified as investing cash flows and be reversed to be operating cash flows.
• Lower interest coverage ratio, as the adjustment would produce lower earnings before interest and tax but higher interest expense.
• The same net cash flows, as capitalization and expensing are accounting adjustments only. They don't affect net cash flows.

During the useful life of the asset this could result in:

• Higher net income, due to a lower depreciation amount.
• The same interest, as all interest costs would be expensed.
• A higher interest coverage ratio, due to higher earnings before interest and tax (same interest expense).

Capitalization of Internal Development Costs

For internally generated intangible assets, it is difficult to measure costs, benefits, and economic lives. Generally, internally generated assets (such as costs of R&D, patents and copyrights, brands and trademarks, and advertising and secret processes) must be expensed in the period incurred.

One exception is research and development (R&D) expenditures which add risk to investment with uncertain future economic benefits. As a result, they must be expensed as incurred in most countries (including the U.S.). SFAS 86 requires that all R&D costs to establish the technological and/or economic feasibility of software must be expensed. Subsequent costs that are beyond the point of technological feasibility can - but don't have to - be capitalized as part of product inventory and amortized based on revenues or on a straight-line basis. The point of technological feasibility is the point when a software prototype has been proven to be technologically feasible, as evidenced by the existence of a working model of the software.

IFRS also requires research costs be expensed but allows development costs to be capitalized under certain conditions.

As you can see, managers have considerable discretion in making decisions, such as whether or when to capitalize these costs and by how much. For software development costs, one particular risk is that capitalized costs will not be realized and a future write-down may be needed.

If companies apply different approaches to capitalizing software development costs, adjustments can be made to make the two comparable.