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Capitalization of costs

When an asset is capitalized, it appears on the balance sheet and there is no charge on the income statement. However, the outflow is recognized as an investing cash outflow. When the asset is depreciated over its useful life, it results in a decrease in net income in the future periods but it has no cash flow implications in those periods.

On the other hand, when an asset is expensed out, the outflow appears under operating activities on the statement of cash flows. There is no recognition of asset on the balance sheet but the whole amount is charged to income statement which results in a decrease in net income in the period. The transaction has no income or cash flow implications in future periods.

Since capitalization can improve both net income and cash flow from operating activities, companies may have an incentive to capitalize expenses. The use of free cash flow, which subtracts both operating and investing cash outflows from operating cash inflows, can be useful in such an analysis. However, if the same basis is used for both financial reporting and tax, companies may have an incentive to expense items to avail tax benefits.

Capitalization of interest costs

Since companies are required to capitalize interest costs incurred in connection with qualifying assets (which are assets whose construction requires a long time), interest expense is ultimately charged to the income statement through depreciation.

Capitalization of interest also affects a company’s cash flows and the coverage ratios calculated to measure a company’s solvency. An analyst must make adjustments so that coverage ratios are calculated by taking both capitalized and expense interest costs. Adjustments may also be needed to cash flows to determine the true cash outflows.

Capitalization of internal development costs

Since IFRS requires capitalization of development costs and expensing of research costs, and US GAAP requires similar treatment for software development costs, and because determining technical feasibility requires significant judgment, adjustments may be needed to a company’s financial statements to make them comparable with another company.

For example, if a company capitalizes development costs, such an adjustment would expense out such costs so that net income increases, the asset recognized on the balance sheet decreases, the net cash flows from operating activities decrease and net cash flows from investing activities increase. This would, in turn, affect ratios such as return on equity, return on assets, etc.

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