Capitalisation of Long-Lived Assets | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In this lesson, we’ll dive into long-lived assets, specifically focusing on the capitalisation of such assets. We’ll discuss the differences between capitalising and expensing, as well as their impact on financial statements and ratios.

Understanding Capitalisation vs. Expensing

Long-lived assets, or non-current assets, include tangible assets like plant, property, and equipment, investment property, intangible assets (including goodwill), and financial assets. When a firm acquires or builds a long-lived asset, the cost involved can either be capitalised or expensed.

• Capitalisation: The cost is recorded initially in the balance sheet as an asset and is depreciated or amortised over the asset’s useful life.
• Expensing: No asset is recorded in the balance sheet, resulting in an immediate reduction of net income.

As a general rule, a company should capitalise costs only if there is a future economic benefit. Otherwise, it should expense the costs immediately.

What Costs Should Be Capitalised?

Here are some guidelines on the types of costs that should be capitalised:

• Purchase, construction, or manufacturing cost of the asset.
• Auxiliary costs necessary to prepare the asset for use (e.g. freight, installation, taxes).
• Subsequent related expenditures that provide more future benefits.

On the other hand, costs that merely sustain the asset’s usefulness should be immediately expensed.

Impact of Capitalisation vs. Expensing on Financial Statements and Ratios

Now, let’s evaluate how capitalising and expensing affect various financial statements and ratios.

1. Income Statement

• Expensing: The entire cost is recorded immediately in the income statement.
• Capitalising: There is no immediate expense recorded in the income statement, resulting in higher net income in the first year.

2. Balance Sheet

• Capitalising: Total assets and shareholders’ equity are higher, but this difference narrows in subsequent years as the asset is depreciated or amortised.

3. Statement of Cash Flow

• Capitalising: Expenditure reported as an outflow from investing activities, resulting in lower CFI and higher CFO as compared to expensing.

4. Ratios

• Capitalising: Initially results in lower debt-to-assets and debt-to-equity ratios, higher return on assets (ROA) and return on equity (ROE), but the opposite effect in subsequent years.

An analyst should be able to note such differences when comparing between firms.

Interest Coverage Ratio

Interest coverage ratio measures a firm’s ability to make required interest payments on its debt. It is calculated by dividing EBIT (earnings before interest and taxes) by interest expense.

• Capitalising Interest: Results in a higher interest coverage ratio in the first year, but lower in subsequent years.

Many analysts calculate the interest coverage ratio based on total interest expense, including capitalized interest. This may be a better measure of the firm’s solvency, as interest is a required payment.

Conclusion

That wraps up our discussion on capitalisation of long-lived assets! We’ve learned the differences between capitalising and expensing, along with their impact on financial statements and ratios. In the next lesson, we’ll dive into various depreciation methods and the impact of the choice of depreciation method on financial statements.