Capitalisation of Long-Lived Assets | CFA Level I FSA
Welcome back! 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. So, buckle up and let’s get started!
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.
A telecom company installed 50 base stations to provide 3G signals to cover a city. The total purchase cost of all the base stations is $10 million. This cost should clearly be capitalised as the base stations are likely to provide future benefits to the company. The company also paid another company $2 million to install all these base stations. This amount should also be capitalised as it is a necessary cost to prepare the base station for use.
Over the years, the company paid $100,000 each year for maintenance to the base station. This is a cost that merely sustain the asset, so it should be expensed. An unexpected repair cost of $500,000 was also incurred after a few stations were damaged by a storm. This repair cost should also be expensed immediately.
Subsequently, the company decides to upgrade the station to be able to provide 4G signals at a cost of $4 million. This cost should also be capitalised as the upgrade is likely to lengthen the useful life of the station, and also allow the company to charge more for the services.
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.
- 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
- 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.
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.